Why do zero coupon bonds always trade at a discount?
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.
Therefore, a zero-coupon bond must trade at a discount because the issuer must offer a return to the investor for purchasing the bond.
Bonds are sold at a discount when the market interest rate exceeds the coupon rate of the bond. To understand this concept, remember that a bond sold at par has a coupon rate equal to the market interest rate.
It is because of the fundamental concern about the inability of the issuers to repay the principal or interest on the debt. However, it is not the same in every scenario. Zero-coupon bonds often start trading at a discounted price even if the issuer's credit quality is higher.
Coupon bonds may trade at a discount, at a premium, or at par. The sensitivity of a bond's price changes in interest rates is the bond's duration. Bonds with higher coupon rates are more sensitive to interest rate changes.
Because zero-coupon Treasuries are more sensitive to interest rates than regular coupon bonds, investors can speculate with them when they expect interest rates to change, earning them higher returns than if they just invested in coupon bonds.
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).
Zero coupon always trade at discount. Zero coupons bonds does not pay any coupon, investor get p[aid th…
Why do some bonds sell at a premium, some at par, and some at a discount? The fundamental reason for bond pricing fluctuations is the demand and supply, and the resulting interest rates of the same.
Fixed returns: The Zero Coupon bond is a perfect choice for those who prefer long-term investment and earn a lump sum. The intention behind this is the assurance of a fixed return, granted the investment has been kept until maturity.
What is the difference between zero-coupon bond and discount bond?
Since zero coupon bonds do not pay any periodic interest payments, investors are not required to pay any taxes on the interest income. However, deep discount bonds may have a coupon rate and investors are required to pay taxes on the interest income.
The bonds are sold at a substantial discount from the face value, with the full value paid to the buyer years later. Zeros usually come in denominations as low as $1,000 and, depending on the maturity, are sold at discounts from face or par value of 50% to 75%.
A deep discount bond does not have to pay coupons, as seen with zero-coupon bonds. Some zero-coupon bonds are offered at a deep discount, and these bonds do not make periodic payments to bondholders. The yield on these bonds is the difference between the par value and the discounted price.
The basic method for calculating a zero coupon bond's price is a simplification of the present value (PV) formula. The formula is price = M / (1 + i)^n where: M = maturity value or face value. i = required interest yield divided by 2.
Below par refers to a bond price that is currently below its face value. Below par bonds are said to be trading at a discount, and the price will be quoted below 100. Bonds trade below par as interest rates rise, as the issuer's credit rating falls, or when the bond's supply greatly exceeds demand.
Also, zero coupon bonds don't pay semi-annual interest, so there is no accrued interest to be paid. These bonds trade flat, meaning they trade without accrued interest.
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.
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).
Taxation of Capital Gains: The capital gain or loss on the sale of zero coupon bonds is also subject to taxation. If the bond is held to maturity, the capital gain or loss will be equal to the difference between the purchase price and the face value.
If a zero-coupon bond is held for 12 months or more, it is treated as a long-term capital asset. Proceeds on maturity less cost of acquiring the bonds will then be taxed as long-term capital gain.
Should you sell bonds when interest rates rise?
Unless you are set on holding your bonds until maturity despite the upcoming availability of more lucrative options, a looming interest rate hike should be a clear sell signal.
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
While some bonds are traded publicly through exchanges, most trade over-the-counter between large broker-dealers acting on their clients' or their own behalf. A bond's price and yield determine its value in the secondary market.
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.
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