Are zero-coupon bonds guaranteed?
U.S. Treasury zero coupon bonds are guaranteed by the federal government as to the payment of principal and interest. However, if you sell a Treasury zero coupon bond prior to maturity, it could be worth more or less than the original price paid.
That said, zero coupon bonds carry various types of risk. Like virtually all bonds, zero coupon bonds are subject to interest-rate risk if you sell before maturity. If interest rates rise, the value of your zero coupon bond on the secondary market will likely fall.
While you'll be able to buy zeros at deep discounts to face value, you won't receive anything in return for your investment until the term of the bond ends. Along the way, you'll be subject to higher levels of interest rate risk (if interest rates rise) and inflation risk (if prices rise generally in the economy).
Credit Risk. Investors in zero-coupon bonds are exposed to the credit risk of the issuer, which may default on its obligation to repay the bond's face value upon maturity.
Zero-coupon bonds are particularly sensitive to changes in interest rates because they do not pay interest until maturity. As a result, the price of a zero-coupon bond will fluctuate more than the price of a coupon-bearing bond with the same maturity and yield.
The Difference for Investors
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. With a normal yield curve, long-term bonds have higher yields than short-term bonds.
The Zero Coupon bonds eliminate the reinvestment risk. Zero-Coupon bonds do not let any periodic coupon payments, and hence a fixed interest on Zero Coupon bonds is guaranteed. Fixed returns: The Zero Coupon bond is a perfect choice for those who prefer long-term investment and earn a lump sum.
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due.
Zero coupon bonds are subject to capital gains taxes and some zero coupon bonds require investors to pay taxes on the imputed interest that accrues on the bonds each year, even though that interest is not paid until maturity (as part of the bonds' face-value).
The main risk associated with coupon bonds is that the issuer might default or go bankrupt before they are able to pay you your full principal amount on the bond's maturity date. This will leave investors who have not sold their coupons prior to this event at a loss of some or all of their money.
Why is a zero coupon bond risk-free?
Zero-coupon bonds are the only type of fixed-income investments that are not subject to investment risk – they do not involve periodic coupon payments. Interest rate risk is the risk that an investor's bond will decline in value due to fluctuations in the interest rate.
Zero-coupon bonds are often perceived as long-term investments, although one of the most common examples is a “T-Bill,” a short-term investment. U.S. Treasury Bills (or T-Bills) are short-term zero-coupon bonds (< 1 year) issued by the U.S. government.
Treasuries are considered the safest bonds available because they are backed by the “full faith and credit” of the U.S. government. They are quite liquid because certain primary dealers are required to buy Treasuries in large quantities when they are initially sold and then trade them on the secondary market.
What Type of Interest Payments Are Earned on a Treasury Bill? The only interest paid will be when the bill matures. At that time, you are given the full face value. T-bills are zero-coupon bonds usually sold at a discount, and the difference between the purchase price and the par amount is your accrued interest.
Without accounting for any interest payments, zero-coupon bonds always demonstrate yields to maturity equal to their normal rates of return. The yield to maturity for zero-coupon bonds is also known as the spot rate.
A bond's coupon rate is the percentage of its face value payable as interest each year. A bond with a coupon rate of zero, therefore, is one that pays no interest.
A zero-coupon bond (also discount bond or deep discount bond) is a bond in which the face value is repaid at the time of maturity. Unlike regular bonds, it does not make periodic interest payments or have so-called coupons, hence the term zero-coupon bond.
Suitable Tenure for Zero Bond Coupons
Zero coupon bonds are instruments for long-term investments. Moreover, the longer the maturity period, the lower the bond's price. The ideal tenure for zero coupon bonds is 10 to 15 years. However, there are also zero coupon bonds of shorter tenures of less than one year.
The duration of a zero-coupon bond equals time to maturity. Holding maturity constant, a bond's duration is lower when the coupon rate is higher, because of the impact of early higher coupon payments. Holding the coupon rate constant, a bond's duration generally increases with time to maturity.
Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a conventional bond, you can typically expect to receive a coupon payment every six months. Zero-coupon bonds, on the other hand, credit you with interest but don't actually pay any until maturity.
How do you hedge a zero-coupon bond?
If your bond is a zero coupon bond that matures at the end of the period for which you want to keep fully invested, you can lock in the bond's initial yield simply by holding it to maturity. If your bond has a positive coupon rate, however, you must reinvest the coupon each six months as you receive it.
A zero-coupon bond will usually have higher returns than a regular bond with the same maturity because of the shape of the yield curve. Zero-coupon bonds are more volatile than coupon bonds, so speculators can use them to profit more from anticipated short-term price movements.
Zero coupon bonds do not pay regular interest, they are sold at a discount in the market. Regular bonds pay bond holders interest payments throughout the lives of the bonds, while zero- coupon bonds do not issue such interest payments, which otherwise known as coupons.
- Report interest each year and pay taxes on it annually.
- Defer reporting interest until you redeem the bonds or give up ownership of the bond and it's reissued or the bond is no longer earning interest because it's matured.
Yes, you can lose money investing in bonds if the bond issuer defaults on the loan or if you sell the bond for less than you bought it for. Are bonds safe if the market crashes? Even if the stock market crashes, you aren't likely to see your bond investments take large hits.
