Stocks and Treasury ‘Zeros’ Are Strange Bedfellows--and a Tough Sell

It’s funny how certain investments sell like hotcakes while others collect dust on the shelf. Consider the small group of funds that hold stocks in combination with zero-coupon Treasury bonds.

Known formally as “balanced target maturity” funds, these unique investments would seemingly make a lot of sense for conservative individuals. They are the only stock-oriented funds that can offer a guarantee that shareholders won’t lose money. The vast majority of bond funds can’t even make that claim.

Yet the balanced target maturity funds have languished since their debut in the late 1980s, and only a couple of portfolios are currently available to investors. All told, the funds in this unusual group have garnered just $1 billion or so in assets--a negligible amount in a $1.8 trillion industry.

What makes the balanced target maturity funds so unusual is the fact that they hold both stocks and zero-coupon Treasuries--odd investment bedfellows. But the combination works precisely because of the strange fit. Here’s why:

Zero-coupon Treasuries are one of the few investments that provide guaranteed appreciation over time. Unlike regular bonds, they don’t make semiannual interest payments to shareholders.

Instead, the bonds are sold at a discount to their ultimate maturity value. The higher the general level of interest rates, the deeper the discount. (The stated interest payment on a bond is known as its “coupon,” which explains how zero-coupons got their name.)

Prices for zeros fluctuate in the bond market, but over time they will increase to the maturity value. This gradual appreciation provides a return to investors.

It’s also what provides a guarantee that shareholders in a balanced target maturity fund will at least recoup their original investment.

All that a fund manager needs to do is purchase enough zeros to compensate for the remote chance that all the stocks in the portfolio might become worthless. Even if every stock got wiped out, the appreciation provided by the zero-coupon bonds would still bail out the portfolio.

In reality, of course, a worst-case scenario like this wouldn’t materialize. If anything, most of the stock holdings would rise in price. The longer the time horizon, the better the odds that they would appreciate.

Investors in balanced target maturity funds can sell whenever they want. But to get the no-loss guarantee, they must stay put until the portfolio liquidates, typically in 10 years. Shareholders also must agree to reinvest all dividends and capital gains into new shares.

And it is worth noting that the no-loss guarantee ignores the effects of inflation. That is, $1,000 received in 10 years won’t have the same value as $1,000 invested today.

Still, an assurance of this type should appeal to some people. But if balanced target maturity bonds are so great, why have investors been so reluctant to jump on the bandwagon?

One reason is that the concept is hard for investors to grasp, says Mike Kosich, a senior vice president for Benham Capital Management in San Mateo, Calif. Benham has put together several zero-coupon bond funds but it hasn’t taken the extra step of adding stocks to the batch.

The concept apparently is a tough one even for brokers to sell, says John Walsh, a partner at Lord Abbett, a New York-based fund company that introduced a balanced “target maturity” portfolio in 1990.

In addition to being backed by zeros, the Lord Abbett fund also has third-party insurance guaranteeing the value of the portfolio. Despite these safeguards, the fund only attracted about $90 million at its peak--a level Walsh calls disappointing--and the company has no current plans to launch another fund.

A second key reason the balanced target maturity funds have languished is that investors can essentially put together their own guaranteed portfolio by combining a favored stock fund with individual zero-coupon bonds.

“Most brokers probably figure they can do it themselves by purchasing individual zeros and a growth fund,” says Bill Chapman, executive vice president in charge of marketing and product management for Kemper Financial Services in Chicago.

The main advantage of individual zeros is that they typically pay slightly higher rates because there are no fund-related expenses to cut into the yield.

The drawback of individual zeros is that investors may forget why they are holding them. It is easy to start viewing different investments as separate components rather than as part of an overall package. “Investors often lose the linkage between the two,” says Chapman.

Of the few balanced target maturity funds currently accepting money, Kemper’s Retirement Series 4 is probably the only one worth considering.

The $120-million fund, which imposes a maximum 5% sales charge, features a mix of 30% stocks, 60% zero-coupon Treasuries and 10% money-market instruments. The guarantee essentially repays the sales charge, in that investors are assured of getting back 100 cents on their original dollar.

Kemper (800-621-1148) plans to offer a new fund each year, and the asset mix in each will vary slightly to reflect current interest rates. When rates are high and zero-coupon discounts wide, fewer bonds are needed to cover the stock-market risks. But when rates are low, as is currently the case, the bonds consume most of the fund’s asset base.