This case study discusses the difference between Cougars and the U.S. Treasury Bonds. It seeks to answer the question of why it would be interesting for an investor to hold a Cougar instead of a U.S. Treasury bond of the same maturity.
Scott P. Mason; Mihir A. Desai
Harvard Business Review (295006-PDF-ENG)
July 12, 1994
Case questions answered:
- What are Cougars? What is its difference to U.S. Treasury Bonds?
- Why would it be interesting for an investor to hold a Cougar instead of a U.S. Treasury bond of the same maturity?
- Calculate the implied spot yields of U.S. Treasuries for all maturities. Use always only the first bond issue listed for each maturity (thus for May 1984 the 9.25er bond, for Nov 1984 the 9.88 bonds, …). Comparing your result with the respective Cougar yields, do the various Cougars bonds seem underpriced or overpriced?
- Was the overall issue of the Cougars underpriced or overpriced?
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Case answers for Cougars
What are Cougars? What is its difference to U.S. Treasury Bonds? Why would it be interesting for an investor to hold a Cougar instead of a U.S. Treasury bond of the same maturity?
A Cougar is a Certificate of Government Receipts. It refers to a specific U.S. Treasury bond initially created by the financial firm A.G. Becker Paribas that segregates the cash flows on the bond into single securities. The process of separating the coupon payments from the principal is frequently referred to as “stripping” the bond.
In the 1980s, a number of investment banks started issuing a different kind of bonds with stripped coupon payments. Besides Cougars, other stripped bonds include CATs, Certificates of Accrual on Treasury Securities sold by Salomon Brothers, TIGRs, Treasury Income Growth Receipts sold by Merrill Lynch, and LIONs, Lehman Investment Opportunity Notes sold by Lehman Brothers.
Instead of being one connected financial asset, Cougars make it possible to sell the bond’s coupon payments and the principal as individual zero-coupon bonds that have a face value of either the coupon payment or the principal. Accordingly, it is possible to split a 20-year U.S. Treasury bond that makes semiannual coupon payments into 41 different securities; 40 zero-coupon bonds that pay the coupon upon maturity and 1 zero-coupon bond that pays the principal amount at maturity. Investors have an incentive to buy any of the 41 newly created zero-coupon bonds as they are issued at a discount from face value.
The main difference with regular U.S. Treasury securities is that, when an investor buys a U.S. Treasury bond, they expect to receive semi-annual coupon payments at a fixed interest rate until maturity and on a regular basis. In contrast to that, holding a Cougar is similar to holding a zero-coupon bond. Therefore, Cougars can be interpreted as parts of a U.S. Treasury bond that is sold and traded individually. In theory, it would be possible to precisely replicate the cash flows of a Treasury Bond by buying every Cougar bond that replicates the Treasury bond’s cash flows.
The existence of Cougars derives from the apparent demand for low-risk zero-coupon bonds. Some investors seem to value the option to receive a lump sum payment over the fragmentation of cash flows over the security’s maturity. The reason for this could be that with zero-coupon bonds, investors do not have to worry about reinvesting cash flows that occur before the principal of the bond is redeemed and so limit the reinvestment risk they are exposed to.
Indeed, Combining Cougars enables an investor to create an individual cash flow pattern by choosing specific components of a Treasury bond for each year, which would not be possible with regular a U.S. Treasury bond. It is worth noting that Cougars and other stripped bonds predominantly exist for state-issued bonds which are widely considered to be risk-free. The lack of stripped corporate bonds indicates that investors do not simply value zero-coupon bonds but in particular low-risk zero-coupon bonds.
A further reason to hold a Cougar over a U.S. Treasury is that the Cougars are…