In the City
Zero coupons
Tony Rudd
The idea of a bond which doesn't pay any interest may not seem wildly attrac- tive at first blush. We have all ended up at one time or another with either a share or even a loan stock which, willy-nilly, didn't pay its appropriate dividend or loan in- terest. And very painful that is. But what has become all the rage in corporate financ- ing in America today, the zero coupon cor- poration bond, is a different matter. It is a deliberate creation rather than a nasty acci- dent on the way to the bank. It represents a loan which is issued at a very substantial discount to the ultimate redemption value, this rate representing the interest. To give an example: the XYZ Corporation issues a $100 million loan stock, repayable at par in ten years' time, at a price of, say, $26 now. The difference between $26 and $100 spread over ten years represents a com- pound interest rate of around 14 per cent. A whole host of famous companies in America, from Pepsi Cola to General Motors, have been issuing these bonds dur- ing the last two years and they have sudden- ly become very popular.
It's not difficult to see why. First, anybody who buys a zero coupon bond is not only 'locking in' a relatively high long- term rate of interest, but measured historically or against the current rate of in- flation in the US which is probably now below 8 per cent, he also 'locks in' the reinvestment rate. The holder of an or- dinary long-dated bond or gilt-edged stock now yielding in the region say of 15 per cent is sure of getting that high yield for the next twenty years or whatever length of time it is until his stock matures. But what he doesn't know is what rate of interest he will be able to reinvest his interest at along the way (always supposing he doesn't actually want to spend it). But not so with a zero coupon bond. There effectively he's got a com- pound rate of interest which is equivalent to reinvesting his money at the current rate, right the way through to redemption. If anybody takes the view that long-term rates are going to fall, then zero Coupon bonds are the best way of taking advantage of that view.
Secondly these bonds have become all the rage with what in America they call the `ERISA' funds, the pension monies which are managed under fairly tight Federal legislation. The performance of these massive funds, which of course don't pay tax, has on the whole been dismal, for the simple reason that, being so large, they find it very difficult to beat the 'averages'. The advent on the scene of these zero coupon bonds which clearly offer a performance far in excess of anything that has so far been achieved by the big funds is equivalent to the last-minute arrival of the US cavalry. The funds are falling over themselves to buy the new-fangled and apparently fault-free bonds.
We say fault-free. Of course there may be a fault but that will take a little while to become evident. The risk in these bonds is that when it comes to the time for redemp- tion the company which issued the stock in the first place might not be around. Of course the very large fund can afford to dis- count that risk by spreading it and buying a dozen or so zero coupons. Not all the com- panies are going to go bust and in the event probably only one or two will. But for the ordinary mortal it would be irritating to have one of those that do.
The question now is whether the appetite for this kind of financing will spread across the Atlantic to London. Certainly there has been a great deal of interest shown. But the great problem, as with everything in this country, is tax. How will the Inland Revenue treat zero coupon bonds? That is the great question. There is obviously the
• danger that the Revenue will impute a no- tional income each year to the holder of a zero coupon bond, even though he hasn't had any interest paid to him. The argument will be that the exercise of purchasing the bond in the first place at a discount which cumulatively is equivalent to a market corn- pound rate of interest, represents the equivalent of rolled-up interest. It could be argued that this is not or could not be assessed to income tax until it is actually paid. After all, in this country you can claim the cost of interest as allowable against taxable income until it is actuallY paid. If a company or an individual adds the interest to the principal of the loan and rolls it up, he can't allow it. So how could somebody holding a zero coupon stock he assessed as he goes along? If that argument is right, then the question will be as to what his position is if he sells his zero coupon bond before maturity. He won't in that case be the person who cashes in at redemption and gets the rolled-up interest. On the other hand if he gets away scot-free then it would follow that the person who bought the zero coupon bond and held it to redemption would pay all the tax which had, as it were, accrued since the issue. In that event of course the right answer would be to sell the bond back to the American market for somebody over there to redeem. But this is only to look at the income tax aspect. Clearly most people would expect the bonds to be assessed to capital gains tax. Obviously if it were possible for British companies to find takers of zero coupon bonds, it would be very useful for -thelu. One of the appalling problems of very high interest rates is that it is almost impossible to finance any form of capital expenditure or expansion with borrowed money. British industry earned around 2 per cent on its assets last year. New money today costs bet- ween eight and ten times that amount. If a new project comes along where a company can see a higher rate it is still the case that during the first year or two it is bound to lose money or at best break even, before it gets into its stride. Yet during these first crucial years the cost of interest will bite deeply into the company's finances. That is why capital expenditure is so appallingly low. The way to get round this is either for companies to go into indexed debt, where they undertake to repay lenders in real pounds adjusted for inflation, in which case the current rate of interest might only be two to three per cent, or, better still, they could issue zero coupon bonds where the cost of interest hadn't got to be paid until much later.
Unfortunately it is all Threadneedle Street to a china lemon that the Inland Revenue will one way or another frustrate the exercise. Yet somebody in the Treasury could well have a look at the problem just to see whether it might not be worth trying to cut through the tax knot in this particular case.
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