If in May 1982 you had bought newly issued 13.75 percent 10-year U.S. Treasury notes, you'd now be getting the principal back.
But if you'd want to reinvest the money for another 10 years in the notes issued in the Treasury's latest quarterly financing, you would have to accept 7.5 percent.
Talk about yield shock!
Of course, if in January 1982 you had bought new 20-year Treasury bonds bearing 14.25 percent coupons, you would have "locked in" their higher rate until they mature in 2002.
While today's longer-term yields seem stingy in comparison -- even if they greatly exceed the current inflation rate -- how will they look 10 years from now? Could they be worth locking in?
After projecting capital supply-demand balances in the United States and abroad, some analysts say they expect higher
long-term interest rates down the road, but others say they expect slightly lower rates.
If by some future year you want an amount of money -- whether for a business, retirement, or other purpose -- that can be accumulated by investing a certain principal sum and reinvesting income at today's Treasury rates, you may not need to wait to see who's right.
You may wish to consider a target maturity bond fund that's primarily invested in zero-coupon Treasury obligations ("zeros") -- separately traded principal and interest components of Treasury securities -- or similar instruments.
Unlike most bond funds, which never mature, target maturity funds mature in a specified target year.
Unlike individual notes or bonds, zeros don't involve reinvestment risk. Funds invested in them are managed to minimize it.
You can see why this is important. If you buy a note or bond and plan to reinvest your interest payments, you have no idea what rates you'll be paid over its life, as anyone who bought the 10-year Treasury notes issued in 1982 can tell you.
Unlike most debt securities, zeros pay no current interest. You buy them at a deep discount -- say, $500 for a $1,000 note. The difference between what you pay and the face value you get at maturity is income. By factoring in the number of years your money is invested, you compute the compound annual rate that represents.
While zeros backed by the Treasury involve no credit risk, they are highly susceptible to interest-rate risk: the risk that prices fall when rates rise. The longer the maturity, the greater the fall. As they approach their maturity dates, their values rise, however.
Because their prices fluctuate with market conditions, zeros are inappropriate for anyone who cannot tolerate their volatility and doesn't expect to hold them until maturity.
Because mutual funds engaging in large transactions can negotiate lower dealer markups than an individual buying only a few thousand dollars' worth of zeros, you're probably better off buying interests in them via a target maturity fund. A fund also makes it easy to add to your position in small increments.
The largest selection is that offered by the Benham Group, which launched the first such funds in 1985. Its six funds mature at 5-year intervals from 1995 through 2020. When the 1995 fund matures, it will form the 2025 fund, says Chairman James M. Benham.
Scudder, which followed in 1986, now offers only two -- 1995 and 2000 funds -- and says it has no plans to add others. Before long, it may only have one. The firm has asked shareholders of the 1995 fund to vote in June to enable Scudder Short Term Bond Fund to acquire it.
The table shows just how volatile these funds' returns have been and how the funds with longer maturities have tended both to rise and to fall more than those with shorter maturities.
Forewarned, you could have expected that.
You should be able to disregard the probable volatility and focus on the rate of return you can expect between the time of your purchase and a fund's maturity. Called the "anticipated growth rate," it can only be approximate -- not as predictable as an individual zero's return -- for a number of reasons. Example: Since investors buy and redeem shares daily, managers frequently have to buy or sell securities at variable prices.
For five of Benham's funds, all managed by David Schroeder, the rates range from roughly 7.25 to 7.75 percent. For the 1995 portfolio, the anticipated rate is about 5.8 percent.
Can investors rely on such projections?
On the basis of limited track records, it would appear that they can. To date, only two zero coupon funds have matured: Benham's and Scudder's 1990 portfolios. When they did, both funds had achieved essentially the rates of return quoted to investors at the time they were offered: 10.5 percent for Benham, 7.8 percent for Scudder.
In figuring whether such a fund would be right for you, be sure to remember taxes. Even if you don't receive dividends from a zero coupon fund, each year's income -- including imputed income -- is subject to taxes, as, of course, actual interest payments would be.
Thus, you might be better off using such funds in a tax-deferred account, such as an IRA. Not surprisingly, Benham says that 32 percent of its target maturity funds' net assets, representing 42 percent of the accounts, are in IRAs.
Target maturity bond funds
.. .. .. .. .. .. .. .. .. .. .. ..Total Return
Fund.. .. .. .. .. .1987.. 1988.. ..1989.. 1990.. 1991.. 1992**
Benham 1995.. .. ..(3.9%) 7.9% .. 15.3%.. 9.2%.. 16.2%..(0.8%)
Scudder 1995 (NL)..(3.8)..7.9.. ..15.7.. ..7.3.. 16.9.. (1.7)
Benham 2000 (NL).. (6.0)..11.5.. .19.8.. ..6.3.. 20.7.. (4.9)
Scudder 2000 (NL)..(8.0)..11.7.. .20.4.. ..4.6.. 20.0.. (5.2)
Benham 2005 (NL).. (10.4).14.5.. .23.9.. ..3.6.. 21.5.. (6.3)
Benham 2010 (NL).. (15.2).15.7.. .28.0.. ..0.3.. 21.1.. (7.1)
Benham 2015 (NL).. (20.2).11.1.. .33.5.. .(3.4)..22.5.. (8.2)
Benham 2020 (NL).. .. .. .. .. .. .. *.. .(4.5)..17.4.. (7.1)
* Commenced operations December 29, 1989.
** January-April 1992.
SOURCE: Lipper Analytical Services.