Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation rate is higher than expected. Many governments issue inflation-indexed bonds, which protect investors against inflation risk by increasing the interest rate given to the investor as the inflation rate of the economy increases.
A zero-coupon bond is a bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the time of maturity.
Advantages and Risks of Zero Coupon Bonds
Zero coupon bonds were first introduced in s, but they did not become popular until the s. When the bond reaches maturity, its investor receives its par or face value. Examples of zero-coupon bonds include U. Treasury bills, U.
In other words, the separated coupons and the final principal payment of the bond may be traded separately. This creates a supply of new zero coupon bonds. The coupons and residue are sold separately to investors. Each of these investments then pays a single lump sum. This method of creating zero coupon bonds is known as stripping, and the contracts are known as strip bonds.
Zero coupon bonds may be long- or short-term investments. Long-term zero coupon maturity dates typically start at 10 to 15 years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U. Treasury bill market is the most active and liquid debt market in the world. The impact of interest rate fluctuations on strip bonds is higher than for a coupon bond.
zero coupon bond
Floating rate bonds are bonds that have a variable coupon equal to a money market reference rate e. Floating rate bonds FRBs are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread i. The spread is a rate that remains constant. Almost all FRBs have quarterly coupons i. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread.
In Europe, the main issuers are banks. There are many variations of floating-rate bonds. FRBs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. FRBs carry little interest rate risk. A FRB has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRB increase in line with the increase in forward rates, which means its price remains constant. Thus, FRBs differ from fixed rate bonds, whose prices decline when market rates rise.
As FRBs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase.
The risk that remains is credit risk. Securities dealers make markets in FRBs. They are traded over the counter, instead of on a stock exchange. In Europe, most FRBs are liquid, as the biggest investors are banks. In the wholesale markets, FRBs are typically quoted as a spread over the reference rate.
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Other bonds include register vs. Fixed rate bonds have a coupon that remains constant throughout the life of the bond. A variation is a stepped-coupon bonds, whose coupon increases during the life of the bond. The coupon rate is recalculated periodically, typically every one or three months. Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity and usually taxed as such. The bondholder receives the full principal amount on the redemption date.
Inflation linked bonds linkers are those in which the principal amount and the interest payments are indexed to inflation. It is one type of floating rate bond. The interest rate is normally lower than for fixed rate bonds, with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. There are also other indexed bonds. Exchangeable bonds allows for exchange to shares of a corporation other than the issuer.
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation.
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In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid.
As a result, the risk is higher.
Therefore, subordinated bonds usually have a lower credit rating than senior bonds. Zero coupon bonds are therefore sold at a discount to their face value. There are two very different reasons why various investors like zero coupon bonds. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable.
Another group of investors likes zero coupon bonds because of their sensitivity to rate changes. Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts. The longer the maturity, the greater the price sensitivity.
Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move. For some investors, being more sensitive to rate changes is a negative rather than a positive.
If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want. Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad.
Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield. Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Despite their dangers, zero coupon bonds let you do some unusual things. Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals.