How certificates of deposit can outrace zero-coupon bonds
One of the lessons in the fable of the tortoise and the hare -- apart from the virtue of persistence -- is that the more glamorous contestant does not always win. That may be the case in the race for better yields between the young and sophisticated zero-coupon bonds and the stodgy old certificate of deposit (CD).
Zeros, we are told, give investors the opportunity to buy a bond at a substantial discount. When it matures, the investor gets the full value, representing the principal and the accumulated interest.
A fancy variety of the zero was invented six years ago (so the legend says) by a stockbroker who was taking a shower. Calling his invention a TIGR, for Treasury Investment Growth Receipt, the wet broker figured out a way to make up a pool of zero-coupon Treasury bonds and separate the their coupon payments and the principal repayments.
Since that shower, TIGRs and their offspring, including CATs and LIONs, have scratched out more than $40 billion in sales.
CDs, meanwhile, have mostly gone in the other direction as interest rates have fallen below 10 percent, then below 8 percent, to the current national average of about 6 percent for a one-year CD. No wonder people look elsewhere; who wants to tie up money for a year when it is uncertain what interest rates might do next month?
Capt. Mark Kimmitt, an assistant professor of finance at the United States Military Academy at West Point, N.Y., believes CDs can be made to outrun zeros.
Captain Kimmitt's military exposure seems to have given him a head for strategy, because his plan for CDs does not involve just buying them and letting them sit there, hoping they'll outpace other investments.
People choosing between CDs and zeros are known as fixed-income investors. While they may invest some of their money in stocks, they want at least part of it in an investment that's reasonably safe; they want it to provide a more or less guaranteed return; and they want the investment to be shielded from large swings in price or erosion in value. While CDs have all three characteristics, Kimmitt says, zeros have only the first two.
Zero-coupon investments, he adds, require an investor to make fairly long-term guesses about the future of interest rates. It might be possible to look ahead a year or two, but since many zeros have a life of a decade or more, a wrong guess -- even a small one -- can be costly. Missing the rate by just one percentage point, say 5 percent instead of 6 percent, can mean a cumulative loss of 20 percent yield in 20 years.
And it's not that easy to sell them early, either. Zeros, Kimmitt says, are much more volatile in a changing bond market than ordinary bonds. The price of a 30-year, $1,000-face-value zero, bought at $35 to yield 11.8 percent, will fall to $17.50 if interest rates rise just three points, he notes.
``If you expect interest rates to rise, the last place you want to be is in a zero,'' Kimmitt says. ``Six months ago, interest rates were three points higher. But now the markets are telling us the pattern of rates is heading up.'' At the very least, Kimmitt believes, rates have stopped falling.
Normally this is not a good time to lock yourself into CDs, either, since doing so now will mean you can't take advantage of higher rates later. But when rates are rising, it is possible to cash in CDs early, take the penalty for early withdrawal, and buy new CDs at a higher rate. If done properly, the increasingly higher yields from the new CDs will offset the penalties and leave you ahead of where you'd be if you had stayed with lower-yielding CDs or zeros, Kimmitt says.
``It's the mirror image of refinancing your house,'' he points out. People who bought houses at 14, 15, or 16 percent have been busy refinancing those loans at 10 or 11 percent. Just as this downward ratcheting of the mortgage makes sense when rates are going down, Kimmitt says, an upward ratcheting makes sense when rates are going up.
At most banks, he notes, the ``substantial penalty for early withdrawal'' is three to six months' simple interest (not compounded) deducted from the final accumulated value. At that rate, a two-percentage-point increase in interest rates would more than offset a four-month penalty. As long as income from the higher rate covers the penalty, you'll be ahead, Kimmitt figures.