PArT 2: VALUATION, rISk AND reTUrNIn some cases, however, companies pledge collateral when they issue bonds. Collateral refers to assets
the bondholders can legally claim if a borrower defaults on a loan. When a bond is backed by collateral,
we say that the bond is secured. In Australia, these bonds are also often called debentures (although
debentures may also include some unsecured debt). Examples of secured bonds are mortgage bonds,
which are bonds secured by real estate or buildings; collateral trust bonds, which are bonds secured by
financial assets held by a trustee; and equipment trust certificates, which are bonds that are often secured by
various types of transportation equipment.Zero-coupon Bonds
Most bonds make periodic interest payments called coupons, but a few bonds, called zero-coupon bonds,
pay no interest at all. Why would anyone purchase a bond that pays no interest? The incentive to purchase
zero-coupon bonds is that they sell below face value. For that reason, zero-coupon bonds are also called
discount bonds or pure discount bonds.^11 An investor who purchases a discount bond receives a capital gain
when the bond matures and pays its face value.
The Australian government issues zero-coupon bonds under the acronym DINGO. This represents a
bond that is a ‘discounted investment in negotiable government obligations’, and is a zero-coupon bond
stripped of the principal and coupons from an Australian government bond.
In New Zealand, government bonds can be stripped into two pieces – the coupons and the principal –
and the coupons can then be traded as a unit or further subdivided into the individual payment dates.
Zero-coupon bonds are relatively rare in New Zealand.
However, government is not the only source for such instruments. Private-sector investors
create ‘zeros’ from regular bonds: by ‘stripping’ the bond payments of coupon and final return of
principal into separate financial instruments, individual zero-coupon bonds can be created. For
example, a three-year regular fixed-income bond with a face value of $100 and a 10% coupon rate
paid annually can be separated into four zeros: a one-year zero bond paying $10 in one year; a
two-year zero bond paying $10 at the end of two years; a three-year zero bond paying $10 at the
end of three years; and a different three-year zero bond paying $100 at the end of three years. The
price of each of the four zero-coupon bonds would be the relevant present value of the payments
to be received.
In the US, the federal government issues such bonds, based on Treasury bonds. They are known
as Treasury STRIPS, with the acronym standing for ‘separate trading of interests and principal
securities’.
Special tax rules apply to zero-coupon bonds. Although it seems that the gains to zero-coupon bonds
are in the form of capital gains that accrue to owners of zero-coupon bonds, taxation authorities in many
countries, including Australia and New Zealand, argue that they are a kind of implicit interest payment.
An investor in zero-coupon bonds must pay taxes on this accrued interest (at ordinary income tax rates)
each year, whether or not the investor sells the bond and realises a gain. Table 4.1 shows how the price
of a zero-coupon bond rises as time passes (assuming that the yield to maturity remains fixed at 5.5%)
and illustrates the capital gain each year.11 Be sure you understand the difference between a pure discount bond – a bond that makes no coupon payments at all – and an ordinary bond
that sells at a discount. An ordinary bond sells at a discount when its coupon rate is below the rate of return that investors require to hold the
bond.collateral
The assets pledged to secure
a loan
debentures
Bonds usually backed by a
claim over tangible property
mortgage bond
A bond secured by real estate
or buildings
collateral trust bond
A bond secured by financial
assets held by a trustee
equipment trust certificate
A bond often secured by
various types of transportation
equipment
pure discount bonds
Bonds that pay no interest and
sell below face value. Also
called zero-coupon bond