Investment Adviser's Recommendation for Zero-Coupon Securities

C

The correct answer is A. While principal strips have no credit risk, there is credit risk in coupon strips.

A STRIP (Separate Trading of Registered Interest and Principal of Securities) security is created by a financial institution by purchasing a Treasury bond and then stripping the coupon payments and the principal payment from the bond. The resulting securities are then sold to investors. Coupon strips are created from the coupon payments, while principal strips are created from the principal payment.

In the given scenario, Eric Webb, an individual investor in a high tax bracket, wants to purchase a 5-year zero-coupon security with no credit risk. His investment adviser recommends U.S. Treasury STRIP securities as an option. Let's analyze the statements to determine which one is true.

Statement A states that while principal strips have no credit risk, there is credit risk in coupon strips. This statement is correct. Coupon strips represent the future coupon payments of the original Treasury bond. Since these coupon strips are sold separately as individual securities, they carry credit risk. The credit risk refers to the possibility of the issuer defaulting on the coupon payments. In this case, the U.S. Treasury has no credit risk for the principal payment, but there can be credit risk associated with the coupon strips as they are separate securities.

Statement B suggests that principal strips have higher reinvestment risk than coupon strips. However, this statement is incorrect. Reinvestment risk refers to the risk that future cash flows from an investment may need to be reinvested at a lower interest rate. Since both the coupon strips and the principal strips of a U.S. Treasury STRIP security have no cash flows until maturity, there is no reinvestment risk associated with either type of strip.

Statement C states that STRIP securities may have negative tax consequences related to accrued interest. However, this statement is not necessarily true. STRIP securities are sold at a discount from their face value, and the difference between the purchase price and the face value is considered accretion or the accrual of interest. For tax purposes, the investor may need to report this accreted interest as income, even though they do not receive any actual interest payments until maturity. However, this does not imply negative tax consequences as it depends on the investor's specific tax situation. It is not accurate to state that STRIP securities will always have negative tax consequences related to accrued interest.

To summarize, the correct statement is A. Principal strips have no credit risk, but there is credit risk associated with coupon strips.