BASIC TYPES OF ZERO COUPON SECURITIES

There are as many kinds of zero coupons as there are bonds, plus a number of interesting variations.

Corporate zeros: Like corporate bonds, done zero-style. Because you are buying into the credit risk of the corporation, corporate zeros are the most risky kind of zero coupon. These are even riskier than a corporate coupon bond (or registered bond), because if the issuing company defaults on the zero, the holder receives no interest at all. Strips and STRIPS: Strips are zeros that are backed by government securities and offered by brokerage houses. Brokerages are proliferating their own proprietary brands of strips under a dizzying array of acronyms: TIGRs, CATS, and other species. Each has different features but works in a similar way. The brokerage buys either U.S. Government or municipal securities and holds them in escrow. It then separates—strips—the principal from the interest and markets zero certificates based on one or the other. One example is the Salomon Brothers CATS (Certificate of Accrual on Treasury Securities), a zero in which the face value is based on the accrued value of the underlying Treasury securities.

The Treasury also offers STRIPS—separate trading of registered interest and principal of securities—based on Treasury bonds. And some of the venerable U.S. savings bonds are actually forms of zeros as well.

Municipal and state governments also issue zeros in the form of zero coupon municipal bonds, which frequently have lower returns but are generally tax-free on the federal level. Finally, zero coupon convertibles can be changed from zeros to other kinds of securities. Companies may issue zero coupon bonds that may be converted into shares of common stock in the company. Convertible municipal zeros can change from zero coupon to regular interest-paying bonds at some time before maturity.

What factors should you consider before you buy zero coupons? We will examine that question next.