Zero-coupon bond

Definition

A zero-coupon bond is a debt security that does not pay periodic interest, or coupons, to the bondholder. Instead, it is issued at a discount to its face value and matures at its face value, allowing investors to earn the difference as profit. This structure influences its duration and convexity characteristics, as zero-coupon bonds are particularly sensitive to interest rate changes and exhibit unique price behavior.

5 Must Know Facts For Your Next Test

1. Zero-coupon bonds have a longer duration compared to coupon-paying bonds with the same maturity, making them more sensitive to interest rate fluctuations.
2. The price volatility of zero-coupon bonds increases as their maturity lengthens, meaning they experience larger price swings with changes in interest rates.
3. Investors purchase zero-coupon bonds primarily for long-term investment goals, as they can provide significant returns if held until maturity.
4. The absence of periodic interest payments makes zero-coupon bonds more advantageous for tax-advantaged accounts since taxes on imputed interest can be deferred.
5. These bonds are often issued by governments and corporations for funding projects or managing long-term liabilities.

Review Questions

• How does the structure of a zero-coupon bond impact its duration compared to traditional coupon bonds?
  • Zero-coupon bonds have longer durations because they do not pay interest until maturity. Since all cash flow is received at once upon maturity, any change in interest rates significantly affects their price. This increased sensitivity results in larger price movements compared to traditional coupon bonds, making them riskier for investors who might need to sell before maturity.
• Discuss the implications of zero-coupon bonds' sensitivity to interest rate changes for portfolio management strategies.
  • The sensitivity of zero-coupon bonds to interest rate changes requires careful consideration in portfolio management. Investors must be aware that during periods of rising rates, the prices of zero-coupon bonds can drop significantly more than those of coupon-paying bonds. This characteristic can lead to increased volatility in a portfolio's value, prompting managers to balance these investments with other assets that may offer more stability or income generation.
• Evaluate the advantages and disadvantages of investing in zero-coupon bonds in terms of long-term investment strategies and tax implications.
  • Investing in zero-coupon bonds offers several advantages for long-term strategies, including the potential for substantial capital appreciation if held to maturity and the ability to defer taxes on imputed interest until the bond matures. However, disadvantages include higher sensitivity to interest rate changes and potential tax burdens due to accrued interest even though no cash is received until maturity. These factors make it crucial for investors to align their risk tolerance and financial goals with the characteristics of zero-coupon bonds.

Related terms

Present Value: The current worth of a future sum of money or stream of cash flows, discounted at a specific interest rate.

Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, expressed as an annual rate.

Duration: A measure of the sensitivity of a bond's price to changes in interest rates, reflecting the weighted average time until cash flows are received.