One of the key advantages of acquiring zero coupon Treasuries is that the investor receives a guaranteed return while avoiding the risk of reinvestment. Coupon payments received over the life of a traditional Treasury bond must be reinvested, sometimes at a lesser rate.
What kind of risk does a zero-coupon bond mitigate?
Except for zero-coupon bonds, most bonds pay monthly interest or “coupon” payments. Zeros, as they’re known, are bonds that don’t have a coupon or interest payment.
If interest rates rise,
Instead of receiving interest payments, you purchase a zero bond at a discount to its face value and are paid the face amount when it expires. For example, a 20-year zero-coupon bond with a face value of $10,000 might cost $3,500. The bond’s issuer pays you $10,000 after 20 years. As a result, zero-coupon bonds are frequently acquired to cover a future obligation such as college fees or a projected retirement payment.
Zero-coupon bonds are issued by federal agencies, municipalities, financial institutions, and corporations. STRIPS is the name of one of the most common zeros (Separate Trading of Registered Interest and Principal Securities). An eligible Treasury asset can be converted into a STRIP bond by a financial institution, a government securities broker, or a government securities dealer. The bond gets stripped of its interest, as the name implies.
STRIPS have the advantage of not being callable, which means they cannot be redeemed if interest rates decline. If your bond is called, you receive cash, and you need to reinvest it, this feature protects you from having to settle for a lower rate of return (this is known as reinvestment risk).
However, zero-coupon bonds come with a variety of risks. If you sell before maturity, zero-coupon bonds, like practically all bonds, are susceptible to interest-rate risk. If interest rates rise, the secondary market value of your zero-coupon bond will certainly fall. Long-term zeros can be particularly vulnerable to interest rate movements, putting them at danger of what is known as duration risk. In addition, zeros might not keep up with inflation. While Treasury zeros pose little danger of default, default risk should be considered while researching and investing in corporate and municipal zero-coupon bonds.
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:
What is the purpose of zero coupon bonds?
A zero-coupon bond is a low-cost investment that can be used to save for a specific objective in the future. A zero-coupon bond does not pay interest on a regular basis, but instead sells at a substantial discount and pays the full face value at maturity. Zero-coupon bonds are appropriate for long-term, specific financial needs that can be met in the near future.
Why are zero coupon bonds so risky?
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.
Why are zero-coupon bonds risk-free to reinvest?
The reinvestment rate is the name given to this new rate. Because they do not issue coupon payments throughout their lifespan, zero-coupon bonds (Z-bonds) are the only fixed-income instrument with no inherent investment risk.
Is there a danger 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.
What are the risks that come with bonds?
Credit risk, interest rate risk, and market risk are the three main risks associated with corporate bonds. In addition, the issuer of some corporate bonds can request for redemption and have the principal repaid before the maturity date.
Who determines the bond risk?
Reviewing a bond’s bond rating is one approach to determine its credit or default risk. Bonds are given ratings by rating organizations to provide investors an idea of the bond’s investment quality and risk of default. Moody’s Investors Service, Standard & Poor’s (S&P), and Fitch IBCA are three major rating agencies.
What are coupon-paying securities, exactly?
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An interest-bearing bond.
return of the coupons that had been clipped from it
certificate. a person who is the owner of a
A coupon-bearing bond is paid on a regular basis (semiannually, annually, etc.).
etc.) for the bond’s lifetime. Bonds issued in the year 2000, for example, are a good example of this.
Coupon payments are made once a year in Europe, but those issued in the United States are paid every six months.
In the United States, semi-annual payments (half-yearly) are common.
The voucher is redeemed twice a year). That is, for a 6% coupon-bearing bond,
The coupon payment on a bond with a face value of $1,000 will be $60.
$30 is the price of a European coupon bond, whereas $30 is the price of a US coupon bond.
will be paid on a six-monthly basis. A coupon-bearing bond can be compared to a savings account.
a collection of zero-coupon bonds
(zeroes), each developing on a different scale
varied maturity dates (obviously, the last one is the most important)
principle redemption plus coupon).
In a structured product, what role does a zero-coupon bond play?
A ‘zero coupon bond’ is a fixed-income instrument that does not pay a coupon and is instead sold at a discount such that the investor receives the full face value at maturity, with the profit equal to the difference between the discounted purchase price and the face value redemption price.
The investor is guaranteed to receive the face value of the bond if the issuer is still solvent and able to repay the bond at maturity. A five-year zero bond with a face value of £1,000 might be sold for £800, a discount of £200.