D e e p ly D i s c o u n t e d B o n d s
J a n n e y C o r p o r at e C r e d i t
S e p t e m b e r 1 6 , 2013
From Zeros to Heroes? The recent rise in rates has
created a universe of deeply discounted bonds.
We assess ways to utilize these securities.
Contents
A Quick Primer on Zeros
Deeply Discounted Bonds
How to Utilize for investing
Conclusion
Information & Disclaimers
•• High-rated corporate bond issues from earlier this year offer such relatively low coupons that
they share some characteristics with zero-coupon bonds.
•• While not a solution to all investors’ needs, these deeply discounted bonds can be attractive for
certain types of strategies, which we discuss below.
With the recent rise in Treasury rates, high-rated corporate bonds that were issued only a few months
ago are now trading at steep discounts to par. The best examples are the 10- and 30-year bonds
issued at or near par by tech giants Apple (Aa1/AA+/NR) and Microsoft (Aaa/AAA/AA+) at the end
of April 2013. Apple’s 2.40% 2023 and Microsoft’s 2.375% 2023 currently trade in the low 90s to
high 80s context, whereas Apple’s 3.85% 2043 and Microsoft’s 3.75% 2043 trade in the mid to low
80s range. This drastic shift stems from the 100 basis point move in Treasury rates in anticipation of
the Fed tapering its bond-buying strategy. Since these and other high-rated low-coupon bonds have
dropped in value so significantly as of late, they share certain traits of zero-coupon bonds. As true
zeros are in short supply in the corporate space, deeply discounted bonds represent an alternative.
A Quick Primer on Zeros
Zero-coupon bonds offer no additional payment to the bondholder beyond the return of principal
at maturity. Instead, to compensate the bondholder, these bonds trade at a steep discount to par
from the start. Over time, the bonds accrete towards par as they approach maturity. The difference
between the maturity value and purchase price is the yield.
Jody Lurie
Corporate Credit Analyst
215 665 6191
[email protected]
See pages 4 for important
information regarding
certifications, our ratings
system as well as other
disclaimers.
JANNEY MONTGOMERY SCOTT
www.janney.com
© 2013 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Deeply Discounted • Page 1
Because zeros offer no interest payments prior to maturity, the bonds have the highest level of exposure to interest rate risk. Duration, which measures how a change in interest rates will affect the
value of the bond, is equal to the years to maturity for zero-coupon bonds, whereas coupon bonds
have duration below maturity, meaning that a movement in interest rates will result in a larger move
in zeros versus coupon bonds. At the same time, zeros eliminate reinvestment risk, the risk of finding a security that offers the same yield-to-maturity as the security the investor already owns. Like
coupon bonds, zeros have a certain amount of credit risk, issuer dependent, in that the change in
credit quality of the issuer could affect the value of the bond.
Deeply Discounted Bonds
When discussing “deeply discounted bonds,” we are referring to those corporate bonds offered by
high-rated corporate issuers which offer such below-market coupon rates, that the securities trade
well below par value. In some sense, these securities can trade almost as if they do not offer any additional coupon payments like zero-coupon bonds. Note that we exclude from this definition bonds
that are nearing default, which could explain the deep discount.
Below we compare Apple’s deeply discounted 30-year bond with Wal-Mart’s above-market coupon
30-year bond and 30-year US Treasury’s STRIPS (zero-coupon bonds). While these three bonds are
not perfectly comparable, we can draw enough comparisons to make a compelling argument for
looking at deeply discounted bonds over alternatives.
j a n n e y c o r p o r at e c r e d i t
S EPTE M B ER 16, 2013
Contents
Example: Deeply Discounted vs. Above-Market Coupon vs. Zero-Coupon Bond
A Quick Primer on Zeros
Deeply Discounted Bonds
How to Utilize for investing
Conclusion
Information & Disclaimers
Type
Security
Deeply
Discounted
Above-Mkt
Cpn
AAPL 3.85
05/04/43
WMT 5 5/8
04/15/41
Zero-Cpn
S 0 05/15/43
Amt
Outs Ratings
($MM)
Yrs
YldMod
Curr Price
Price
to
toDuration
Price i+100bps i-100bps
Mty
Worst
3,000 Aa1/AA+/NR
29.6
16.0 4.99% 82.5
70.5
97.6
2,000 Aa2/AA/AA
27.6
14.3 4.88% 111.2
96.5
129.4
1,000 Aaa/AA+/AAA 29.7
29.1 4.09% 30.1
22.5
40.3
Source: Janney FISR; Company Reports; FINRA TRACE; i+100bps=interest rates up 100bps, i-100bps=rates down 100bps
A few items to note:
1. Coupon: Only the Wal-Mart bonds offer an above-market coupon, even with assuming a
certain level of credit risk. The STRIPS will always offer a below-market rate (of zero), while the
Apple bonds, even without a credit risk premium, offer a coupon that is below current market
rates for the asset class.
2. Price & Yield: Apple’s bonds do not carry as large a discount as the 30-year STRIPS, but they
also do not price at a premium like Wal-Mart’s 30-year bonds. Because Apple’s bonds have a
coupon, despite its below-market rate, the discount to par is not as severe as that of the STRIPS.
Wal-Mart’s bonds, however, price at a premium due to their above-market rate currently offered.
Deeply discounted bonds can
be attractive for long-term
investment strategies with
specific timing needs, such
as higher education or
retirement planning.
3. Duration: Apple’s deeply discounted bonds offer shorter duration than true zeros. The small
coupon offsets somewhat rate volatility, allowing the price of Apple’s bonds to be less volatile
than that of STRIPS. In general, while deeply discounted bonds possess more volatility to interest rates than either par or premium bonds, the risk is not as large as for true zeros.
How to Utilize Deeply Discounted Bonds for Investing
Deeply discounted bonds can be attractive for investors wanting to purchase bonds from high quality
corporate issuers for a long-term investment strategy and to fill the corporate zeros void. While firms
have issued corporate zeros since the early 1980s, as of August 2013, only $4.8B in corporate zeros
across 12 securities remained outstanding.(1) Deeply discounted bonds can, therefore, stand in as a
proxy with less exposure to interest rates than zeros.
Deeply discounted bonds can be attractive for long-term investment strategies with specific timing
needs, such as higher education or retirement planning. The fact that deeply discounted bonds trade
well below their par value allows investors planning for a long-term investment horizon to put smaller amounts away now and receive a larger amount (plus some cash flows along the way) when the
securities mature. These bonds allow investors to manage long-term investment horizons through
an expected fixed amount of cash flows. Additionally, as compared to par bonds, taxes on long-term
deeply discounted bonds can be smaller on a present value basis (assuming both mature at par), as
a portion of tax requirements are held up in principal, which investors can elect not to report until
the bonds mature.* Other ways to use deeply discounted bonds in lieu of zeros include creating a
portfolio of synthetic par bonds. We discuss this concept further in a note from fall 2012 found here.
Conclusion
JANNEY MONTGOMERY SCOTT
www.janney.com
© 2013 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Deeply Discounted • Page 2
While there are a few corporate bond zeros outstanding currently, the recent movement in rates
has caused many high-quality low-coupon bonds to fall more into the realm of zero-coupon bonds.
These bonds can be used in a similar investing strategy as traditional zero-coupon bonds, but discount bonds have decreased volatility towards interest rate changes over zero-coupon bonds. Additionally, there may be added benefits to owning these securities, as a portion of the gains on these
securities would not be taxed until the bondholder closes the position.
(1) Including zero-coupon bonds with the following criteria: greater than $100MM outstanding, not RegS or 144A, USbased company, USD-denominated, and investment grade by Moody’s or S&P. *Consult your tax advisor for additional
details about potential tax implications.
j a n n e y c o r p o r at e c r e d i t
S EPTE M B ER 16, 2013
Contents
A Quick Primer on Zeros
Select List of Deeply Discounted Bonds Rated Single A or Better (10- and 30-year)
Cusip
Issuer
Deeply Discounted Bonds
How to Utilize for investing
Conclusion
Information & Disclaimers
Mod
Ratings
Duration
MR Yld-toPrice Worst
037833AK6 APPLE INC
5,500
2.40% May-23
8.3
Aa1/AA+/NR 88.7 3.82%
46625HJJ0 JPMORGAN CHASE
2,000
3.38% May-23
7.9
A3 /*-/A-/A
89.8 4.71%
00206RBN1 AT&T INC
1,500
2.63% Dec-22
7.9
A3/A-/A
87.8 4.24%
674599CE3 OCCIDENTAL PETE
1,250
2.70% Feb-23
8.1
A1/A/A
90.2 3.96%
037411BD6 APACHE CORP
1,200
2.63% Jan-23
8.1
A3/A-/BBB+
89.7 3.96%
755111BX8 RAYTHEON CO
1,100
2.50% Dec-22
8.0
89.6 3.85%
594918AT1 MICROSOFT CORP
1,000
2.38% May-23
8.4
20826FAA4 CONOCOPHIL CO
1,000
2.40% Dec-22
8.1
A3/A-/AAaa/AAA/
AA+
A1/A/A
89.7 3.72%
740189AG0 PRECISION CAST
1,000
2.50% Jan-23
8.1
A2/A-/NR
89.9 3.80%
369550AU2 GENERAL DYNAMICS
1,000
2.25% Nov-22
8.1
A2/A/A
89.7 3.57%
69349LAG3 PNC BANK NA
1,000
2.70% Nov-22
7.8
A3/A-/A
90.3 3.98%
1,000.0
1.88% Aug-22
8.0
Aa3/AA-/A+
85.5 3.82%
459200HG9 IBM CORP
As true zeros are in short
supply in the corporate
space, deeply discounted
bonds represent an
alternative.
Amt Outs
Cpn Mty
($MM)
Cusip
Issuer
Amt Outs
Cpn Mty
($MM)
Mod
Ratings
Duration
90.9 3.50%
MR Yld-toPrice Worst
00206RBK7 AT&T INC
3,043.8
4.35% Jun-45
15.3
A3/A-/A
81.8 5.58%
037833AL4 APPLE INC
3,000.0
3.85% May-43
16.0
Aa1/AA+/NR 82.5 4.99%
369604BF9 GEN ELECTRIC CO
2,000.0
4.13% Oct-42
15.8
Aa3/AA+/NR 89.5 4.80%
00206RBH4 AT&T INC
1,955.1
4.30% Dec-42
15.2
A3/A-/A
85.2 5.30%
87612EBA3 TARGET CORP
1,500.0
4.00% Jul-42
16.0
A2/A+/A-
87.8 4.78%
244199BF1 DEERE & CO
1,250.0
3.90% Jun-42
16.1
A2/A/NR
87.6 4.69%
459200HF1 IBM CORP
1,107.3
4.00% Jun-42
16.0
Aa3/AA-/A+
88.7 4.72%
452308AR0 ILLINOIS TOOL WK
1,100.0
3.90% Sep-42
16.2
A1/A+/NR
85.4 4.84%
637071AK7 NATIONAL OILWELL
1,100.0
3.95% Dec-42
16.1
A2/A-/NR
87.8 4.72%
63946BAJ9 NBCUNIVERSAL MED
1,000.0
4.45% Jan-43
15.4
A3/A-/BBB+
89.9 5.12%
931142DG5 WAL-MART STORES
1,000.0
4.00% Apr-43
16.1
Aa2/AA/AA
88.0 4.76%
03523TBQ0 ANHEUSER-BUSCH
1,000.0
3.75% Jul-42
16.3
A3/A/A
84.7 4.73%
Source: Janney FISR; Company Reports; FINRA TRACE; only shows single A rated or greater bonds with $1B in issuance
size sorted first by amount outstanding and then by average 30-day trading volume
JANNEY MONTGOMERY SCOTT
www.janney.com
© 2013 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Deeply Discounted • Page 3
j a n n e y c o r p o r at e c r e d i t
S EPTE M B ER 16, 2013
Contents
Analyst Certification
A Quick Primer on Zeros
I, Jody Lurie, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately
reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is,
or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
Deeply Discounted Bonds
How to Utilize for investing
Conclusion
Information & Disclaimers
Janney Montgomery Scott LLC (“Janney”) Debt Research Disclosure Legend
Janney may seek compensation for investment banking services for any company in this report in the next
3 months.
The research analyst is compensated based on, in part, Janney’s profitability, which includes its investment
banking revenues.
Additional information available upon request.
Definition of Issuer/Company Outlooks
Janney FIS employs a rating system which considers the company, but not any specific debt or equity securities of the company and is
not making a recommendation with regard to any specific debt securities of the company. Outlooks reflect our opinion about how credit
factors of the company may affect its credit rating(s).
Positive: Janney FIS believes there are factors which point towards improving issuer or sector credit quality which may result in potential
credit ratings upgrades
Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in
either potential credit ratings upgrades or downgrades.
Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result
in potential credit ratings downgrades.
Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit
ratings downgrades.
Definition of Sector/Industry Ratings
Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in
terms of total return.
Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset
class in terms of total return.
Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in
terms of total return.
Janney FIS Outlooks Distribution as of 09/16/2013
Outlook
Positive
Stable
Cautious
Negative
Count
9
28
8
1
Percent
19.6
60.9
17.4
2.2
IB Serv./Past 12 Mos.
Count
Percent
0
0
0
0
0
0
0
0
Benchmarks
Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade
Credit, High Yield Credit, and Municipals employ the “Barclay’s U.S. Aggregate Bond Market Index” as a benchmark.
Treasuries: Janney FIS ratings employ the “Barclay’s U.S. Treasury Index” as a benchmark.
Agencies: Janney FIS ratings employ the “Barclay’s U.S. Agency Index” as a benchmark.
Mortgages: Janney FIS ratings employ the “Barclay’s U.S. MBS Index” as a benchmark.
Investment Grade Credit: Janney FIS ratings employ the “Barclay’s U.S. Credit Index” as a benchmark.
High Yield Credit: Janney FIS ratings for employ “Barclay’s U.S. Corporate High Yield Index” as a benchmark.
Municipals: Janney FIS ratings employ the “Barclay’s Municipal Bond Index” as a benchmark.
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of the issuers mentioned in this publication.
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This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by
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only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official
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may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or
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JANNEY MONTGOMERY SCOTT
www.janney.com
© 2013 Janney Montgomery Scott LLC
Member: NYSE, FINRA, SIPC
Deeply Discounted • Page 4
Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without
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