An interesting article here talks about the fact that ~10 years ago Warren Buffett bet Seides $1 million that the S&P500 would beat a bunch of hedge funds. The times about up, and Warren won.
They put the collateral for the bet in a zero coupon US gov’t treasury bond. Over the same 10 years that bond went up:
Annually, the S&P returned ~7%, hedge funds ~2% and the bonds 11%.
10 year interest rates at the time were ~4%. Today they are 2%. Because it was a zero coupon bond that 4% was locked in. That obviously made the bond jump in value. Now with the Fed hiking I’d imagine that bond wouldn’t perform the same way…
What are zero coupon Treasuries?
In general, a zero coupon bond is any bond which doesn’t pay periodic interest. Earnings (interest) accrete over the life of the bond as the difference between a deeply discounted purchase price and the bond’s maturity value. Zero coupon bonds are priced to earn yields prevailing in the current market. A zero coupon Treasury bond is simply a zero coupon bond on which payment is derived from an underlying Treasury security. This bond is created by taking a Treasury note or bond and first separating its coupon payments from the final principal payment in a process called coupon stripping. After this “stripping” process, securities are issued to match the maturity of each of the coupon payments with a final maturity payment. To illustrate this process, suppose a $100 million face value 10-year Treasury note paying a coupon rate of 10% is purchased to create zero coupon Treasury securities. The cash flow from this bond would be 20 semi-annual payments of $5 million each, plus one final payment of $100 million. Receipts are then issued to coincide with the maturity date and value for each of the coupon and final maturity payments. This process creates 20 coupon strip receipts with a maturity value of $5 million each, and one maturity receipt with a principal value of $100 million. These newly created strips are sold as separate securities. The price of the receipts would be discounted to reflect current market rates. This general process is the same for all of the zero coupon Treasury products.
Why buy zero Treasuries?
Purchasing zero coupon Treasury securities provides investors with a number of advantages:
• Guaranteed return/reinvestment risk eliminated — One of the main benefits of purchasing zero coupon Treasuries is that the investor earns a guaranteed return while eliminating reinvestment risk. With conventional Treasury bonds, coupon payments received over the life of the bond must be reinvested, possibly at lower rates. Zero coupon bonds eliminate this risk since there are no periodic payments. The investor’s return is generated over the life of the bond as the interest accumulates, a process called accretion.