Beware the Treasury's feline menagerie. CATS and TIGRS fine for IRAs -- but they're not for short-term investing

Cat scratches. That's what some people feel like they're getting after investing in CATS and TIGRS. These feline-named instruments are zero-coupon securities backed by US Treasury bonds and notes. Firms like Merrill Lynch and Salomon Brothers have been selling them for the last couple of years, primarily for individual retirement accounts (IRAs), Keoghs, and education savings.

But some people have also bought these creatures for short-term investing -- or what unexpectedly turned out to be short-term investing. They are the ones getting nicked.

This is the season, as anyone who has seen the newspaper ads knows, for selling IRAs and Keoghs. And CATS and TIGRS are almost tailor-made for the retirement accounts. However, the IRA ads touting CATS (Certificates of Accrual on Treasury Securities) and TIGRS (Treasury Investment Growth Receipts) are also drawing investors interested in high government-backed returns but who are unaware of all the tax consequences and may have some unpleasant surprises if they try to sell early.

Zero-coupon bonds are issued by corporations and the US Treasury. Instead of a bunch of coupons that are clipped and turned in for cash twice a year, ``zeroes'' simply make a lump-sum interest payment at the end of the contract period, hence their name.

Well, the ingenious folks on Wall Street found a way to break apart the interest and principal portions of the Treasury debt and sell them separately as CATS, TIGRS, LIONS, or whatever.

A 20-year TIGR, for instance, bought for $1,912 ($2,000 after fees) yielding 11.75 percent, compounded semiannually, would return $19,125 at maturity, broken down this way: $1,912 for return of principal, $4,495 in interest, plus $12,718 in interest on interest.

This works just fine in theory and as long as the investor doesn't need the money for a major portion of the 20 years. But there are some pitfalls. First, the fees you pay for these securities can vary a great deal from broker to broker. And the more you have to pay a broker, the less you have working for you.

Second, these securities are often purchased in the secondary market and, if sold before maturity, are sold in the secondary market, too. This means you have to be concerned with the differences in bid and asked prices. When you buy TIGRS or CATS, you pay the quoted asked price; if you sell before maturity, you get the quoted bid price. Since asked prices are higher than bid prices, this creates another margin that eats into your yield.

Third, one of the things that makes zero-coupon bonds so attractive -- locking in a yield over a long period of time -- can make them a problem if you need your money soon after investing. If rates have gone up significantly since you bought the security, this liquidity problem means the price you get for selling early could more than offset any gains.

The liquidity problem may be partly answered by another seller of Treasury-backed securities -- the US Treasury. The Treasury recently began a program called Separate Trading of Registered Interest and Principal of Securities (STRIPS). Here, the Federal Reserve's wire transfer system is used to trade the principal and interest portions of Treasury securities separately. By eliminating the broker as middleman and -- eventually -- creating a large secondary market, STRIPS should be cheaper to purchase and easier to trade.

But before buying CATS, TIGRS, STRIPS, and the other exotically named creatures backed by Treasury debt, investors need to be sure of their financial goals and tax situation.

``They are very appropriate for tax-shelter-type investing,'' says William Freund, director of financial planning at Prescott, Ball & Turben, a Cleveland brokerage. They are also good for college saving under the Uniform Gifts to Minors Act, where gains are taxed at the child's rate, says Ned Costello, marketing director at Fidelity Investments in Boston. Fidelity recently started selling CATS through its brokerage subsidiary, Fidelity Brokerage Services Inc.

With both retirement accounts and education savings, the goals are long term and the tax consequences minimized. Otherwise, even though you don't receive the interest payments until the end of the term or until you sell the securities, the Internal Revenue Service figures each year's interest as taxable income.

For some people, Mr. Freund says, yields on CATS and TIGRS are good enough that they're willing to pay the taxes on this imputed income. But for many others, this ``hidden'' tax angle, plus liquidity and pricing problems, means most investors should be thinking ``buy and hold'' with these financial kittens.

In a recent ``Moneywise'' on mutual fund fees and charges, several funds were listed that use the ``12b-1'' provision to subtract marketing and distribution costs from the funds' assets. Two of the funds in the list provided by the American Association of Individual Investors -- the Dreyfus Funds and Ivy Fund -- should not have been included. None of the funds carrying the Dreyfus name use 12b-1, but the firm does have five funds under the name ``General'' that it sells through dealers. These are the only Dreyfus-managed funds using the 12b-1 rule. And, while the Ivy Fund has used 12b-1 in the past, it stopped doing this when it hired a new outside money manager. If you would like a question considered for publication in this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.