Zero Coupon Bond

8 Key excerpts on "Zero Coupon Bond"

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  The Economics of Financial Markets

  • Roy E. Bailey(Author)
  • 2005(Publication Date)
  • Cambridge University Press

    (Publisher)

  Zero-coupon bonds play an important role in financial analysis, for reasons shortly to be explained. While zero-coupon bonds do exist (e.g. treasury bills, very short-term govern-ment debt), they are less commonly issued than theory might suggest. Given their importance in financial analysis, zero-coupon bonds are often created synthetically as stripped bonds , or ‘strips’. To create a stripped bond, a financial intermediary purchases a coupon-paying bond and ‘repackages’ it in the form of a sequence of zero-coupon bonds, one for each coupon (each coupon of the underlying bond becomes the face value of one of the stripped bonds) and one for the face value paid at maturity. The trading of stripped government bonds has become active, with official sanction and support, in several markets since the 1980s. A coupon-paying bond can be viewed as a portfolio of zero-coupon bonds. For example, a three-year bond, with face value $1000, promising to pay a coupon of $40 every six months, can be treated as a portfolio of five zero-coupon bonds each with face value $40, each maturing separately at six-month intervals, and one three-year zero-coupon bond with face value $1040. Viewing coupon-paying bonds from this perspective simplifies the analysis, which can otherwise prove intractable. Variable coupons Rather than the promise of a constant coupon, the bond indenture might contain a rule for calculating regular payments over the life of the bond. Examples include: (a) floating-rate bonds, for which the coupon is linked to an observed interest rate that varies across time; and (b) index-linked bonds, for which the coupon is linked to a specified index of prices, such as the retail price index in Britain (see chapter 13, section 13.2). 12.1.3 Default In the event that the issuer defaults on any clause of the contract (e.g. by failing to make a coupon payment), it is at the discretion of the bondholders to make a legal claim on the issuer’s assets.

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  Investing in Fixed Income Securities

  Understanding the Bond Market

  • Gary Strumeyer(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Every 12 months that you own the bond you will receive $600. That interest payment does not change. Whether you paid more than $10,000 for the bond or less will not affect the coupon rate. It remains the same. If market interest rates go up and the same issuer sells a new bond with the same maturity date but with a coupon rate of 6.5 percent, that does not affect the coupon rate on the bond you previously purchased. The coupon rate on that bond remains at 6 percent and you will continue to receive your $600 each year. Whether the price of your bond goes up or down from the price you paid has no effect on your $600 payments. As long as no change is specified in the original bond or note that would change the coupon rate (i.e., if it is not a variable rate note), it remains unchanged until the debt is paid. ZERO COUPON Some debt instruments pay no coupon interest until the bond is fully repaid. Such debt instruments are called Zero Coupon Bonds. We are all somewhat familiar with one variety of Zero Coupon Bond—U.S. savings bonds. The U.S. savings bond is purchased at a discount to its final payoff value. The payoff value is also called the face amount or maturity value. The difference between its purchase price and its face amount represents the accumulation of interest earned, but not previously paid. The U.S. savings bond shares these attributes with other zero coupon issues that run the gamut from the very short-term, such as 91-day Treasury bills or commercial paper issued by corporations, and the very long-term, such as 30-year Treasury zeros or equally long corporate or municipal zero coupon debt issues. Even though there is no coupon interest paid until maturity on a zero coupon instrument, there is a market rate of interest that determines the discounted price of the debt instrument

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  Investments

  An Introduction

  • Herbert Mayo(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  When they are issued, the coupon is less than the yield on comparable debt, so the bond sells for a discount. Since the bond does pay some interest, the amount of the discount is less than the discount associated with a Zero Coupon Bond. Over time the discount disappears as the interest accrues and the bond is redeemed for its face value at maturity. The taxation of the accrual for an original-discount bond is the same as the taxation of a Zero Coupon Bond. The taxation of the accrued interest that is earned but not received until matu -rity suggests investors may have little reason to purchase Zero Coupon Bonds. There is, however, one major exception: tax-deferred pension plans. The tax on the accrued interest is deferred until the funds are withdrawn from the account. So the primary reason for acquiring Zero Coupon Bonds is to use them as part of a tax-deferred retire -ment account. R E TIRING D E BT Debt issues must ultimately be retired, and this retirement must occur on or before the maturity date of the debt. When the bond is issued, a method for periodic retire -ment is usually specified, for very few debt issues are retired in one lump payment at the maturity date. Instead, part of the issue is systematically retired each year. This systematic retirement may be achieved by issuing the bond in a series or by having a sinking fund. Serial Bonds In an issue of serial bonds , some bonds mature each year. (Preferred stock may also be issued in series.) This type of bond is usually issued by corporations to finance spe -cific equipment, such as railroad cars, which is pledged as collateral. As the equipment serial bond A bond issue in which specified bonds mature each year. Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300

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  Bonds

  A Concise Guide for Investors

  • M. Choudhry(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Usually FRNs pay a fixed margin or spread over the specified reference rate; occasionally the spread is not fixed and such a bond is known as a variable rate note. Because FRNs pay coupons based on the three-month or six-month bank rate, they are essentially money market instruments and are treated by bank dealing desks as such. Index-linked bonds An index-linked bond has its coupon and redemption payment, or some- times just one of these, linked to a specified index. When governments issue index-linked bonds the cash flows are linked to a price index such as consumer or commodity prices. Corporates have issued index-linked bonds that are connected to inflation or a stock market index. Zero-coupon bonds Certain bonds do not make any coupon payments at all and these are known as zero-coupon bonds. A zero-coupon bond or strip has only one cash flow, the redemption payment on maturity. If we assume that the maturity payment is say, £100, the issue price will be at a discount to par. Such bonds are also known therefore as discounted bonds. The difference between the price paid on issue and the redemption payment is the inter- est realised by the bondholder. As we shall discover when we look at strips, this has certain advantages for investors, the main one being that there are no coupon payments to be invested during the bond’s life. Both governments and corporates issue zero-coupon bonds. Corporate bonds These are bonds issued by non-government entities, and can be conven- tional bonds or a variation on a theme. Corporate bonds exhibit varying degrees of credit risk, because they are not risk-free like gilts. The yield payable on a corporate bond will depend on how risky its issuer is perceived in the market. Bond basics 23 High yield bonds These are also known as junk bonds, and are issued by companies that have a credit rating below investment grade.

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  An Introduction to the Bond Markets

  • Patrick J. Brown(Author)
  • 2006(Publication Date)
  • Wiley

    (Publisher)

  This could be a property and could be worth more than the capital lost. Many eurobonds just specify in their prospectus a ‘negative pledge’. As discussed later, this is just a pledge not to issue bonds in the future with a prior call on the assets of the company. However, in Europe it often does not stop the company taking out a bank loan that has a higher call on the assets. 30 An Introduction to the Bond Markets What is the coupon going to be on the bond? The bond could have a fixed-rate coupon, a floating-rate one, an index-linked coupon or no coupon at all. Depending on the investor’s requirements, some of these options may not be appropriate. For example, a zero-coupon bond is not appropriate for an investor who wants a regular income, but it might be ideal for a pension fund or insurance company manager that has a future liability that coincides with the redemption of the bond. What is the coupon payment frequency of the bond? A bond that pays quarterly is worth more than one that pays semi-annually, which in turn is worth more than one that only pays interest once a year, as you get the coupons earlier. What is the investor’s expected direction of interest rates and over what time horizon? If you expect interest rates to fall then purchasing a fixed-rate issue could be preferable to a floating-rate note, for with the latter your income will fall. Other things being equal, if your prediction is correct, the capital value of the fixed-rate issue should rise, which will not be the case with the floating-rate note. What is the period of the loan? Although most loans specify a final maturity date, the terms of the loan sometimes allow the issuer or the investor to demand an earlier redemption. What is the duration of the loan? This is different to the period of the loan. For example, compare a zero-coupon 10 year bond where you do not get any money back for 10 years with a 10 year bond that has an 8 % coupon.

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  Fundamentals of Financial Instruments

  An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

  • Sunil K. Parameswaran(Author)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  The reason is that in practice a potential investor will have a choice between plain-vanilla bonds and zero-coupon bonds. To draw meaningful inferences, it is imperative that the discounting technique be com-mon. Since the cash flows from plain-vanilla bonds are usually discounted on a semi-annual basis, we choose to do the same for zero-coupon bonds. A zero-coupon bond will never sell at a premium. It will always trade at a discount except at the time of maturity, when it will trade for the face value. That does not mean that buyers of such a bond will always experience a capital gain. If they were to Valuing a Bond in Between Coupon Dates 141 buy and hold it to maturity, then obviously they will have a capital gain. But if they choose to sell it prior to maturity they may well end up with a capital loss as we shall demonstrate. EXAMPLE 4.3 Alex bought a zero-coupon bond when there were 10 years to maturity. The pre-vailing yield was 10% per annum. Today, that is, a year later, the YTM is 12% per annum. The purchase price was 1 , 000 ( 1.05 ) 20 = $376.89. The price at the time of sale can be shown to be $350.34. Thus, in this case the investor has a capital loss of $26.55. VALUING A BOND IN BETWEEN COUPON DATES Thus far we have assumed that we are valuing the bond on a coupon date. That is, the next coupon is exactly one period away. Now let us consider a more realistic situation where the price of the bond is sought to be calculated in between coupon dates. Consider the timeline depicted in Figure 4.1. As you can see, the length of time between “0” and “1” is less than one period, whereas the other coupon dates are spaced exactly one period apart. To value the bond at time “0” we will proceed in two steps. First let us value the bond at time “1.” At this point in time, we will get a cash flow of C/2. There are N − 1 coupons left after this and the face value is scheduled to be received N − 1 periods later.

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  Fixed Income Securities

  Tools for Today's Markets

  • Bruce Tuckman, Angel Serrat(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  Since a Zero Coupon Bond has only one cash flow at maturity, its yield is simply the spot rate corresponding to that maturity. A 9% coupon bond, on the other hand, makes cash flows every six months. Its yield, therefore, is a complex average of all of the spot rates from terms of six months to the bond’s maturity, although the greatest weight is 2.5% 3.0% 3.5% 4.0% 4.5% May-11 May-16 May-21 May-26 May-31 May-36 May-41 Yield Maturity Date Zero-Coupon Par 9% Coupon Tsy Notes and Bonds FIGURE 3.3 Yields of Long-Term Hypothetical Securities Priced with C-STRIPS as of May 28, 2010 104 THE RELATIVE PRICING OF SECURITIES WITH FIXED CASH FLOWS on the spot rate corresponding to the bond’s largest present value, namely, that of the final payment of coupon plus principal. Furthermore, since the term structure of interest rates in the figures slopes upward, any weight this complex average places on the shorter-term spot rates lowers that average below the spot rate at maturity. Hence the yield on the 9% bond has to be lower than the yield on the 0% bond. The par bonds, with coupons between 0% and 9%, discount a lot of their present value at the shorter-term spot rates relative to Zero Coupon Bonds, but discount little of their present value at those shorter-term rates relative to the 9% bonds. Hence, the yield of a par bond of a given maturity will be between the yield of the 0% and 9% bonds of that maturity. While not illustrated here, if the term structure slopes downward, then the argument just made would be reversed and the zero coupon yield curve would be below the 9%-coupon yield curve. The fact that fairly priced bonds of the same maturity but different coupons have different yields-to-maturity is called the coupon effect. The implication of this effect is that yield is not a reliable measure of relative value. Just because one fixed income security has a higher yield than another does not necessarily mean that it is a better investment.

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  Bond and Money Markets

  Strategy, Trading, Analysis

  • Moorad Choudhry(Author)
  • 2003(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  In the context of yield represented by a par bond price, one might occasionally encounter yield to par or par yield , which is the yield for a bond trading at or near its par value (100 per cent). In practice this will refer to a bond price between 99 and 101 per cent, and the par yield is essentially the coupon rate for a bond trading at or near par. 4.4 Yield on a zero-coupon bond Zero-coupon bonds, sometimes known as strips, have only one cash flow, the redemption payment on maturity. Hence the name: strips pay no coupon during their life. In virtually all cases zero-coupon bonds make one payment on redemption, and this payment will be par (100). Therefore a zero-coupon bond is sold at a discount to par and trades at a discount during its life. For a bond with only one cash flow it is obviously not necessary to use (4.4) and we can use (4.10) instead. ( ) 1 n C P rm = + (4.10) where C is the final redemption payment, usually par (100). This is the “traditional” approach. Note that P , the price of a zero-coupon bond, has only one meaning because there is no “dirty” price, since no accrued interest arises. Equation (4.10) still uses n for the number of interest periods in the bond’s life. Because no interest is actually paid by a zero-coupon bond, the interest periods are known as quasi-interest periods . A quasi-interest period is an assumed interest period, where the assumption is that the bond pays interest. It is important to remember this because zero-coupon bonds in markets that use a semi-annual convention will have n equal to double the number of years to maturity. For annual coupon bond markets n will be equal to the number of years to redemption. We can rearrange (4.10) for the yield, rm : ( ) 1 1. n C rm P = − (4.11) E XAMPLE 4.7(i) ( ) 1 5 100 1 77 795 rm . = − = ■ A zero-coupon bond with five years to maturity is trading at € 77.795. What is its yield to maturity? 0.0515009. The yield of the bond is 5.15%.

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