New FICOs Can Pay if They’re Just Put Away
Savings and loans are teetering. A record number are failing. The carnage strains the already ailing Federal Savings & Loan Insurance Corp., the government agency that insures S&L; deposits.
Not a happy story. But there is a way you can assist the troubled industry--and lock in a nice yield to boot.
You can buy a new type of security called FICO zero-coupon bonds. Proceeds from the bonds, first issued about a month ago and primarily sold through major brokers, go to FSLIC. And the bonds are fully backed by a U.S. government agency--meaning they are just about as safe as Treasury securities, says the leading bond rating firm of Standard & Poor’s.
Even better, they currently yield as much as one-third to three-quarters of a percentage point more than comparable Treasury zero-coupon bonds.
When bought in zero-coupon form--the type that you buy at a discount from face value but receive no periodic interest payments like conventional bonds--FICOs could make excellent additions to your individual retirement account or Keogh plan. You also might want to give them to your children to save taxes and help pay for their college education.
But beware: Unless you are convinced that interest rates are headed downward, plan to hold them to maturity. Selling them may be costlier than other bonds, and you could lose part of your principal if interest rates rise.
“Individuals should buy these for tax-deferred accounts” like IRAs, says Robert Cirino, fixed-income analyst at S&P; Outlook, the investment newsletter of Standard & Poor’s, which is touting the bonds. “They should be put in your account and held to maturity.”
The introduction of FICO zeros come at a time when zero-coupon bonds in general are enjoying resurgent popularity among conservative small investors, who like their relatively high yields and are still weary of stocks following last October’s market disaster.
Coupons Repackaged
“We have seen good retail demand, particularly in the under-10-year maturity,” says William C. Oliva, director in the capital markets group at Salomon Bros., a leading underwriter of the bonds.
Zeros are created when a broker “strips” all the interest coupons from a conventional bond. Those coupons--each representing one interest payment at an exact date in the future--are then packaged and sold as separate, zero-coupon bonds.
In this case, FICO zeros are stripped from conventional bonds issued by a federally sponsored agency called the Financing Corp. (FICO), created last year by Congress to raise money for FSLIC. The bonds are backed by U.S. Treasury securities; interest payments come from assessments on the S&L; industry.
Unlike Treasuries, FICO bonds are not backed by the “full faith and credit” of the U.S. government, Oliva says. But because FICO is a government-sponsored enterprise, “a number of people believe the bonds are top-quality bonds,” Oliva says. “If there were a problem, there is an extremely high likelihood that the U.S. government would make good on its obligation.”
Standard & Poor’s considers FICOs to be very safe, equivalent to top AAA-rated issues, Cirino says.
The FICO zeros are suitable for small investors for several reasons. First, they can be bought for very small initial investments, even less than $100.
That is because, like other zero-coupon bonds, FICO zeros are sold at discounts to their face value. The longer the maturity, the deeper the discount. You don’t get regular interest payments; instead, you accrue the interest on the bond by its gradual appreciation until maturity, when you get its face value.
The advantage is that you lock in your initial yield for the life of the bond, and the bond’s gradual appreciation in effect reinvests your accrued interest payments at that yield, thus compounding your gains over the years.
Not Widely Traded
The face value on FICO zeros is only $1,000, compared to $20,000 for the conventional FICO bonds. Thus, a FICO zero with a 30-year maturity and a $1,000 face value lately has been available for as little as $57, before commissions. That constitutes an annual yield to maturity of 9.8%.
If you don’t want to hold the bond that long, five-year FICO zeros with $1,000 face values lately have sold for about $620. That’s a yield to maturity of 9.45%.
FICO zeros yield more than comparable Treasury bond zeros in part because they are new and thus not widely traded in secondary markets and partly because they are not quite as safe as Treasuries.
But before rushing to your broker and buying a batch of FICO zeros, be aware of their drawbacks. Like Treasury zeros, they are taxable every year for the accrued interest, even though you don’t receive that interest in cash until maturity. Thus, you will be taxed on money you don’t have.
That is why many experts recommend that you hold FICO zeros in an IRA or Keogh plan, where their interest buildup will be tax deferred. Or you can give zeros to your children under 14 years old. The first $500 of youngsters’ interest income is tax free, and the next $500 is taxed at their tax rate.
Another drawback of FICO zeros: Like other zeros, they can fluctuate sharply in price before maturity. When interest rates fall, they rise in price; but when interest rates rise, they plummet in value.
Of course, if you’re the gambling type and think interest rates will fall, you can make a nice profit trading FICO zeros. But because they are new and thus not widely traded yet, they have somewhat higher transaction costs than more liquid Treasury securities.
Those higher costs come in the form of higher “bid and ask spreads”--the difference between the price a broker will pay for your bond, and the price you will have to pay to buy it.
These higher transaction costs and lower liquidity are another reason why conservative investors might be better off buying FICOs--and just sitting on them, some experts say.
“You’re getting a great deal,” says Jay Goldinger, an investment broker with Capital Insight in Beverly Hills. “But if you try to get out, you’ll get massacred.”
