The Zero Coupon Bond: Pricing and Charactertistics
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What is Zero Coupon Bond?
Compare Investment Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Related Articles. Therefore this Bond is the one where the sole return is the payment of the nominal value on maturity. The difference between the current price of the bond i.
These Bonds avoid the risk of Reinvestment of Coupon Bonds as Interest Rates keep changing with the passage of time which impacts the Yield to Maturity of such coupon bearing Bonds. Since there are no interim cash flows, the investor is assured of a fixed rate of return.
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Usually, these Bonds are issued for a longer time frame which can be used by a potential investor to align with their life goals such as Marriage, Children Education, and retirement and so on. Thus a smart investor based on their time horizon can invest in different maturity Zero-coupon Bonds by paying a smaller amount initially as Zero-coupon Bonds are issued at deep discounts one can buy more with lesser amount and stagger them as per their career and life goals without getting impacted by the volatility.
- What is a Zero Coupon Bond?!
- Yield to maturity;
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Not all Zero-coupon Bonds have a ready secondary market which results in illiquidity. Furthermore, in case of any urgent need funds, it is difficult to liquidate the same without getting a major haircut in value. They have a single cash inflow for the Investor which happens at the maturity and as such these bonds have the greatest Duration which results in Interest Rate Risk. Further, These are issued with call provisions which allow the issuer of such Bonds to redeem the bonds prior to their maturity at dates and prices which are predetermined at the time of issue of such Bonds.
How to Calculate Yield to Maturity of a Zero-Coupon Bond
In such cases, the Investor is left with the risk of reinvesting the proceeds at the rates available at the time of redemption which will obviously be less than the earlier slated yield on the redeemed bonds. Furthermore one has to pay tax on the accrued interest on such bonds every year.
Once a bond has been stripped, a trustee directs the appropriate amount of the interest or maturity payment to the security holders. The holder of a zero coupon receives the par amount of the particular term of the zero that she holds. If we start on December 1, the first two payments are identical to a 6-month and 1-year T-Bill. The basic math is easy. What should an investor pay for the 1-year coupon? As a rough cut, forgetting the compounding of interest interest-on-interest and the conversion to semiannual yields, we know that 5.
Pulling out our trusty bond calculator, we can actually do the calculation. At a semi-annual yield of 5.
Related zero coupon bonds calculate yield maturity
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