A zero-coupon bond is a bond that does not make any periodic interest payments. Instead, the investor gets the face value of the bond when it matures. For example, a $1,000 zero-coupon bond with a 10-year maturity would be worth $1,000 10 years from now.
Most bonds make periodic interest payments (known as “coupons”) until they mature. The coupon rate is the interest rate paid by the bond issuer. For example, a bond with a $1,000 face value and a 6% coupon rate will pay $60 in interest each year (6% of $1,000). At the end of the 10-year period, the investor would receive both the final coupon payment and the face value of the bond ($1,000).
Zero-coupon bonds are sometimes called “zeros” or “strips.” They are often used by investors who want to reinvest their coupons at a higher interest rate or who want to achieve a specific financial goal (e.g., saving for retirement).
Zero-coupon bonds are less risky than bonds that make periodic interest payments because there is no chance that the issuer will default on its coupon payments. However, zero-coupon bonds are more sensitive to changes in interest rates than other types of bonds. This is because changes in interest rates affect the present value of future cash flows (i.e., the face value of the bond). For example, if interest rates rise from 6% to 7%, the present value of a 10-year, $1,000 zero-coupon bond will decline from $610 to $543.
What are Zero Coupon Bonds?
A zero-coupon bond is a debt security that doesn’t pay interest (a coupon) but is traded at a deep discount, rendering a profit at maturity. When the bond matures, the investor receives one lump sum equal to the initial investment plus the accrued interest.
Zeros vs Coupon Security
A zero coupon bond is a debt security that does not pay periodic interest payments and instead pays one lump sum at maturity. The majority of bonds make periodic interest payments to the bondholder during the life of the bond, typically semi-annually. These bonds are called coupon bonds or simply coupons. Zeros are popular with investors who seek to minimize interest rate risk, reinvestment risk, and who desire simplicity.
Pricing of Zero Coupon Bonds
A zero-coupon bond (also known as a pure discount bond or simply a discount bond) is a bond that does not pay periodic interest (also known as a coupon) payments, but instead pays one lump sum at maturity. Zero-coupon bonds are typically issued at a substantial discount to its face value, reflecting the market’s expectations of interest rates over the life of the bond.
Yield to Maturity
Yield to maturity (YTM) is the total return expected on a bond if the bond is held until it matures. YTM takes into account both interest payments (coupons) and any capital gain or loss that results from a change in the bond’s market price. For example, if a bond has a face value of $1,000, pays interest of $50 per year (i.e. has a coupon rate of 5%), and has 10 years left to mature, its YTM would be 5%.
To calculate YTM, one must first know the current market price of the bond, the coupon rate, the face value of the bond, and the number of years remaining until maturity. The formula for YTM is as follows:
YTM = [Coupon Rate + ((Market Price – Face Value)/Years to Maturity)]/2
The current yield of a zero coupon bond is its cash yield, which is defined as the percentage of the face value that is paid out each year. For example, if a bond has a face value of $1,000 and a current yield of 5%, then it will pay $50 each year. The current yield does not take into account the time value of money, so it does not reflect the total return of the bond.
Zeros have higher durations than coupon securities because all of their cash flows are concentrated at maturity. This means that zeros are more sensitive to changes in interest rates than coupon securities. For example, if interest rates rise by 1%, the price of a zero with 10 years to maturity will fall by more than the price of a 10-year Treasury note.
Yield to Call
A zero coupon bond is a debt security that does not pay periodic interest (coupons) and is traded at a deep discount from face value. The buyer of the bond is receiving a stream of interest payments in the future, and as such, the yield to call (YTC) for a zero coupon bond is the internal rate of return (IRR) of those payments until the call date. The YTC will always be equal to or higher than the yield to maturity (YTM) because there is no reinvestment risk with a YTC calculation – all cash flows are known with certainty. The Yield to Call can be thought of as the “investment return if held until called.”
To calculate the YTC, we need to know three things:
-The price of the bond
-The call price
-The time to call
Risks of Zero Coupon Bonds
Zero coupon bonds are often touted as a safe investment, but there are several risks associated with them. The biggest risk is that of interest rate changes. If rates go up, the price of your bond will go down, and vice versa. Another risk is that of inflation. If inflation increases, the purchasing power of your bond’s fixed payments will decrease.
Interest Rate Risk
Zero coupon bonds are subject to interest rate risk. When interest rates rise, the price of zero coupon bonds falls. This is because investors can get a higher yield elsewhere. For example, if you bought a ten-year $1,000 zero coupon bond with a yield of 3%, and interest rates subsequently rose to 4%, the bond would be worth less than what you paid for it.
Reinvestment risk is the primary risk associated with zero coupon bonds, and it is the risk that the investor will not be able to reinvest the proceeds from the bond at a rate of return that is equal to or greater than the rate of return of the bond.
The reinvestment rate is the interest rate that an investor will earn on new investments. For example, if an investor purchased a zero coupon bond with a face value of $1,000 and a yield to maturity of 5%, the investor would expect to earn $50 per year in interest payments. If, at the end of the year, the investor could only reinvest those interest payments at a 3% interest rate, the reinvestment rate would be 3%. In this scenario, the investor would be losing out on 2% in potential returns.
While all investments carry some degree of reinvestment risk, it is especially important for investors in zero coupon bonds to be aware of this risk. This is because with zero coupon bonds, all of thereturn comes at maturity, so if rates have fallen by the time the bond matures,the investor will not have had any opportunity to benefit from higher rates alongthe way.
Investors can manage reinvestment risk by laddering their investments, which involves investing in bonds with different maturity dates. This way, as each bond matures, there will always be another bond coming due soon after that can be reinvested at hopefully higher rates.See related articles on what is unique about zero-coupon bond related to treasury bonds? here, or this article regarding spread on treasury bonds explained.
To conclude, Treasuries offer a fixed income stream and are backed by the U.S. government, making them a very safe investment. Zero coupon bonds are also a fixed income security, but they are not backed by the government. Instead, they are backed by the issuer, which may be a corporation or another entity. Because of this, there is more risk involved with investing in zero coupon bonds.