These are suitable for long-term goals like retirement and are preferred by pension funds
By Sunil K. Parameswaran
Zero coupon bonds, which are referred to as ‘Zeroes’ by traders, are bonds that do not pay any coupons, and hence the name. You may wonder that if there are no coupons, why would any investor be interested. The answer is that they are issued at a discount from the face value, and always trade below the face value. In other words, zero coupon bonds always trade at a discount prior to maturity and can never trade at a premium.
Holding till maturity
An investor who buys the bond and holds till maturity will get the face value at the end, and the difference between the face value and the price paid, is the return for him. In other words, zero coupon bonds compensate the holder at maturity for the principal that is invested at the outset, the interest on this principal, and the interest on interest for interest accrued along the way. Hence, unlike plain vanilla bonds, there is no reinvestment risk for the holder.
Zero coupon bonds also have the highest price sensitivity for a given maturity. This is because the entire cash flow is concentrated in the form of a single bullet repayment at maturity. Consequently, bullish investors, who are anticipating rate declines in the market, prefer such bonds since they hope to reap a high capital gain if their prediction is correct. If the yield remains constant the price of a zero coupon bond will increase with the passage of time. If the yield were to decline the capital gain would be higher.
For a mild increase in yield there may still be a capital gain with a decline in the time to maturity, but for larger yield changes, there will be a capital loss. A zero coupon yields a single cash flow and consequently can be priced by discounting it at either an annual rate or a semi-annual rate of interest.
In practice, the market discounts the face value of such bonds using a semi-annual rate. This is because an investor who is contemplating an investment in bonds, has a choice between coupon paying bonds and zero coupon bonds. Since the cash flows from the former are discounted semi-annually, to facilitate comparisons, the cash flow from the zero coupon bond should also be discounted semi-annually.
Long-term investors such as pension funds and insurance companies like zero coupon bonds. They can lock in a rate of return by buying these bonds and holding them to maturity, and need not worry about reinvesting intermediate cash flows, for there are none.
A plain vanilla bond may be perceived as a portfolio of zero coupon bonds, which mature at successive six monthly intervals. This is because each cash flow from a plain-vanilla bond is like a zero coupon bond maturing at that instant. Hence to rule out arbitrage, the price of the mother plain-vanilla bond must be equal to the sum of the prices of the baby zero coupon bonds.
The writer is CEO, Tarheel Consultancy Services