Zeros: The Ultimate Discount Bonds
Zeros: The Ultimate Discount Bonds
Zero coupon bonds are the ultimate discount bonds. They are sold at a deep discount from par, but they do not pay periodic interest.
Things To Know
- Zeros are more susceptible to interest rate changes than regular bonds are.
Why buy them at all?
Why would you buy a bond that did not pay regular interest? Because you can purchase it well below its par value. A zero coupon bond is purchased at discount and redeemed for its full par value at maturity. The issue price of a zero coupon bond is calculated as the present value of the par amount discounted at the coupon rate for the maturity of the bond. For example, a twenty-year bond with an 8 percent coupon maturing at $1,000 would be worth $215 today. The closer a zero is to its maturity, the more it is worth.
Zeros are more susceptible to interest rate changes than regular bonds are. Their market prices are more likely to rise when interest rates fall. Conversely, their prices fall more when interest rates go up. For investors intending to hold onto zeros until maturity, their high volatility is not an issue.
They cost less
One advantage of zeros is their significantly lower purchase price as compared to traditional coupon-paying bonds. Another advantage of zeros is the reliability of their return, because they have no reinvestment risk. This is the risk that an investor will have to reinvest his or her annual interest payments at lower interest rates. Your total return with zeros will always equal the difference between what you paid for the bond and its par.
