PROTECT INVESTED PRINCIPAL USING A ZERO COUPON BOND HEDGE
Written for Publication in The GLOBAL EDGE INTERNATIONAL Blog
|A thoroughly uninteresting picture of a mathematical formula for zero-coupon bond computations.|
|A remotely relevant picture with more "eye appeal" than the above mathematical formula.|
IMPORTANT NOTICE: THE INFORMATION CONTAINED IN THIS DOCUMENT SHOULD NOT BE CONSTRUED BY THE READER AS BEING LEGAL, FINANCIAL, TAX, ACCOUNTING, ECONOMIC OR INVESTMENT ADVICE. NO OFFERING OF SECURITIES OR OTHER INVESTMENT INTERESTS OF ANY TYPE IN ANY ENTITY IS MADE HEREBY, NOR IS A SOLICITATION FOR THE PURCHASE OF SECURITIES OR OTHER INVESTMENT INTERESTS OF ANY TYPE IN ANY ENTITY MADE HEREBY. THIS DOCUMENT IS INTENDED FOR GENERAL INFORMATIONAL PURPOSES ONLY, AND IS NOT INTENDED FOR DISTRIBUTION OR TRANSMITTAL BY ANY MEANS. ANY REPRODUCTION OR TRANSMITTAL OF THIS DOCUMENT, EITHER IN WHOLE OR IN PART IS EXPRESSLY PROHIBITED, UNAUTHORIZED AND MAY CONSTITUTE A VIOLATION OF APPLICABLE LAWS. THIS DOCUMENT IS COPYRIGHT 2015 BY DOUGLAS CASTLE.
In many acquisition or investment transactions, the primary concern of the purchaser or investor is the preservation of invested principal. A zero coupon bond hedge functions as a form of principal protection insurance. Is is expensive, but it works very well, provided that the issuer of the zero coupon bond is creditworthy. Also, please note that this particular strategy does not guarantee the timely payment or liquidity of the principal. It merely means that over a designated time if you hold the the zero-coupon bond up to its maturity that upon that maturity date, you can collect the full amount of your principal.
The bonds are bought in the appropriate amount to facilitate the hedge [see the examples below] and are deeply discounted from their future value. These bonds are said to accrete value as interest payments accumulate toward the future value of the bond. And the annual accumulated interest (which is not paid to the holder, but which is instead allowed to accumulate) is taxable in many cases, even if you haven't received any amount of the accretion. For tax purposes, the accreted (but unpaid) interest on the bond may be taxable annually, despite the lack of cash flow to support and cover the amount of this payment. It is for this last reason, that an ideal pairing for a zero coupon bond is with a depreciable real estate or other depreciating asset investment; in these cases the accretion issue is often well offset by the amount of depreciation against it.
Without getting involved in a discussion of the tax ramifications associated with zero coupon bonds, let's examine how they may be used in some illustrative examples below:
In this particular example (and one which is demonstrative of the most extremely conservative case for purposes of illustration only), let us assume that we have $1,000,000.00 of principal to invest. If we invest approximately (all numbers are estimates) $500,000.00 in a potentially high-yielding investment opportunity, but we wish to guarantee the return of our full $1,000,000.00 principal regardless of the level of success or lack of success that we will experience in the investment activity, we may choose to simultaneously purchase a 10-year, 7.1% zero coupon bond for $500,000.00 which will accrete to the sum of $1,000,000.00 in 10 years, independent of all other variables. In essence, this means that we will receive our total principal of $1,000,000.00 back at the end of 10 years regardless of the performance of the investment opportunity in which we had invested the $500,000.00.
While the zero coupon bond as a form of “return of principal guarantee insurance” does reduce our yield somewhat on successful investments, it also provides us with the comforting assurance that invested principal (and in the above case, even our uninvested principal!) will be kept intact and returned to us if the zero coupon bond is simply held to maturity, regardless of the performance of the portion of funds invested in the riskier but more potentially high-yielding investment opportunity.
The true “cost” of this form of guarantee is actually 7.1% per year which we could have earned on the $500,000.00 if we'd had it to invest in alternative opportunities. But we must look at this cost in its appropriate perspective: If the investment opportunity in which we had placed the funds had generated a return of 30% per year, the cost of the protection afforded us by the zero coupon bond hedge would have been extremely worthwhile and actually quite minimal.
Variations on the above formula are available using smaller denominations of zero coupon bonds purchased for the protection of principal of lesser amounts or to a lesser extent. The above example in the first paragraph is the most extreme case. Had we wanted to merely purchase “return of principal guarantee insurance” for only the $500,000.00 invested amount, we could have purchased a 10-year, 7.1% zero coupon bond for $250,000.00, which would have accreted to the sum of $500,000.00 at the end of ten years. This approach, which is admittedly a bit more aggressive than the one set forth in the example in the first paragraph, would have left us an additional $250,000.00 of principal in our discretionary investment fund to do with as we chose.
In utilizing the zero coupon bond hedge, the strategic objective is to pair a high risk-reward investment opportunity with the smallest comfortable level of zero coupon bond present value in order to maximize the spread between the investment upside potential and the cost of the “return of principal guarantee insurance”. The obsessive use of this hedging strategy can be too conservative and counterproductive; however the well-reasoned use of this strategy can provide a more conservative approach to investing in more aggressive investment opportunities with greater potential returns.
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principal, protection, investing, insurance, credit enhancements, zero coupon bonds, GEIconsulting, Douglas E. Castle, hedging, risk, protecting investments, bond computations, accretion
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Douglas Castle for Global Edge International Consulting Associates, Inc. and The Global Edge International Blog
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