Zero coupon bonds are stripped Treasuries. An investor purchases a zero coupon bond and is guaranteed to receive a fixed amount at a specific time in the future. They were a very popular investment in the 80’s, a time when the yield on long-term government bonds was considerably higher than today’s yield. In, and of themselves, they were an attractive investment for those who wanted certainty regarding their future nest egg.
For example: If a 40 year old investor wanted to make certain they had $1 million dollars at age 70 they could purchase a zero coupon bond yielding 8.5% per annum for $86,518. No problem, but the creative minds on Wall Street, knowing that most of their customers did not follow the bond market that closely, saw an opportunity to “stick it to their customers” hoping no one would notice. And it was not complicated. They realized they could sell this bond with a market value of $85,518, at a much higher price and pocket the difference. The price of the bond with a yield of 8% would be $99,377. In essence creating a commission of $12,859 or 15%.
As the broker looked at the screen, he or she had three different prices for each bond. The less sophisticated the potential investor, the higher the price and the bigger the commission. It was not unusual to see commissions as high as 25%, but if the broker wanted to sell it at that price, he or she needed “manager approval.” Hmmmm, I wonder why?
Was it legal? Yes, like a car dealer, they could mark up the product to whatever price they could get. But that didn’t make it right. And it was easy because very few investors could tell you within one half a percent what the yield was on long-term bonds. But that one half percent makes a huge difference in the price and the profit for the Wall Street Bank.
Zeros were also used to create investment products that seemed to take the risk out of what were very risky investment vehicles. How about an investment that gave you the upside of trading commodities while you were guaranteed to get all your money back, even if the commodity trades went against you. “Too good to be true?” Of course, and next time I will show you why.
Note: These examples were from my experience back in the 80’s, but I am certain the game continues. Your only real defense is to avoid getting investment advice from a salesperson.