Finally, Treasury zeros are extremely vulnerable to inflation. Inflation, as we all know, is bad for the bond market. Without employing leverage or derivatives, Treasury zeros are the most aggressive bond investment available. Inflationary pressures are frequently accompanied with interest rate hikes, which would result in considerable losses for zero-coupon Treasury bonds. Furthermore, inflation lowers the value of the primary.
Example 1: Annual Compounding
John is interested in purchasing a $1,000 zero-coupon bond with a 5-year maturity date. The bond’s yearly interest rate is 5% compounded annually. What will John pay today for the bond?
Example 2: Semi-annual Compounding
John is interested in purchasing a $1,000 zero-coupon bond with a 5-year maturity date. The bond has a 5-percentage-point interest rate that is compounded semi-annually. What will John pay today for the bond?
Reinvestment Risk and Interest Rate Risk
Reinvestment risk refers to the possibility that an investor may be unable to reinvest the cash flows (coupon payments) from a bond at the needed rate of return. Zero-coupon bonds are the only fixed-income assets that do not entail periodic coupon payments and hence are not subject to investment risk.
The danger that an investor’s bond would lose value owing to interest rate variations is known as interest rate risk. Interest rate risk impacts all sorts of fixed-income assets and is crucial when an investor decides to sell a bond before maturity.
Consider the case of John, who paid $783.53 for a $1,000 zero-coupon bond with a 5-year maturity and a 5% annual interest rate compounded annually. Assume that interest rates increase from 5% to 10% immediately after John purchases the bond. What would the bond’s price be in such a scenario?
If John sold the bond right after buying it, he would lose $162.61 ($783.53 $620.92).
More Resources
Thank you for taking the time to read CFI’s Zero-Coupon Bond guidance. The following extra resources are strongly recommended for continuing to acquire and enhance your knowledge of financial analysis:
Are zero-coupon bonds a better investment?
- A standard bond pays interest to bondholders, whereas a zero-coupon bond does not pay interest to bondholders.
- Because of the curvature of the yield curve, a zero-coupon bond will typically offer better returns than a conventional bond of the same maturity.
- Because zero-coupon bonds are more volatile than coupon bonds, they can be used by speculators to profit on expected short-term price swings.
- While zero-coupon bonds might help investors avoid gift taxes, they can also result in phantom income tax difficulties.
What are the benefits and drawbacks of zero-coupon bonds?
Because zero-coupon bonds do not pay interest on a regular basis, their issuers must devise a strategy to make them more appealing to investors. As a result, the rates on these bonds are frequently greater than on ordinary bonds.
A US Treasury zero often yields at least one percentage point more than its standard Treasury counterpart, and in some cases much more. In 2018, a 10-year Treasury zero yielded as much as 3.1 percent on an annualized basis, while 10-year T-notes yielded.2 percent.
The PIMCO 25+ year zero-coupon bond ETF, a managed fund consisting of a range of long-term zeros, has a current yield-to-maturity rate of 1.54 percent as of November 2020. A 20-year Treasury bond currently has a yield of 1.41 percent.
It may seem insignificant, but thanks to compounding, it adds up especially over time.
When is the best time to buy a zero-coupon bond?
Bonds with a zero coupon pay no interest for the duration of the bond’s existence. Rather, investors purchase zero coupon bonds at a significant discount to their face value, which is the amount the investor would receive when the bond “matures,” or matures.
Zero coupon bonds typically have long maturities, with many lasting ten, fifteen, or even more years. These long-term maturity dates enable a person to save for a long-term objective, such as paying for a child’s college education. A deep discount allows an investor to put up a small quantity of money that will rise over time.
In the secondary markets, investors can purchase several types of zero coupon bonds issued by a range of issuers, including the US Treasury, companies, and state and local government agencies.
Because zero coupon bonds pay no interest until they mature, their prices fluctuate more in the secondary market than other forms of bonds. Furthermore, even though zero coupon bonds do not require payments until they mature, investors may be subject to federal, state, and local income taxes on the imputed or “phantom” interest that accrues each year. Some investors avoid paying taxes on imputed interest by acquiring municipal zero coupon bonds (assuming they live in the state where the bond was issued) or the rare tax-exempt corporate zero coupon bonds.
Do zero-coupon bonds command a higher price?
What circumstances allow a zero-coupon bond to be sold at a premium? A zero-coupon bond, unlike a coupon bond, has no recurring cash flow and only receives one lump-sum payment of the face value at maturity. As a result, a zero-coupon bond will always be sold for less than its face value.
What is a zero-coupon bond’s interest rate?
A zero-coupon bond is a type of debt product that pays no interest. Zero-coupon bonds are sold at a steep discount and pay out the entire face value (par) at maturity. The return on a zero-coupon bond is calculated as the difference between the purchase price and the par value.
Why are zero-coupon bonds so dangerous?
Because all interest payments on zero coupon bonds are compounded and paid at maturity, they are more sensitive to interest rate changes than bonds that pay interest semiannually. The higher the volatility, the longer the bond’s maturity.
What is the profit potential of zero-coupon bonds?
When a company issues bonds, it is effectively borrowing money from investors in exchange for interest payments. Investors are enticed to buy bonds in the first place by interest payments. Zero-coupon bonds, on the other hand, do not pay interest. Rather, investors profit from zero-coupon bonds by purchasing them at a discount to their face value and collecting both the principal and interest payments at maturity. (The difference between the bond’s purchase price and its real face value is represented by the interest at maturity in this scenario.) While a regular bond with a face value of $10,000 might sell for $10,000, a zero-coupon bond with a face value of $10,000 might sell for $5,000 at first.
What are the advantages of redeeming a zero-coupon bond early?
b) Zero Coupon Bonds and Taxation In the case of zero coupon bonds, the investor does not receive any regular coupon benefits during the term of the instrument, i.e. no interest payments or benefits are received or collectable before the maturity or redemption date.
Is there a risk of reinvestment with zero coupon bonds?
Reinvestment risk is the possibility that an investor will be unable to reinvest cash flows, such as coupon payments, at the same pace as their present return. Because no coupon payments are made, zero-coupon bonds are the only fixed-income instrument with no investment risk.
When it comes to bond investing, reinvestment risk is the most common, but every investment that generates cash flow exposes the investor to this risk.