Zero-coupon bonds have been around for a long time. Why are they termed as such? It is because,unlike conventional bonds,which pay interest at periodic intervals known as coupons,these securities do not make any payouts prior to maturity. There are,therefore,no periodic coupons,and,hence,the name zero coupon.
Think of them as investments where the principal plus the accumulated interest is paid out in a bullet form at the time of maturity. Many of us may be familiar with cumulative interest debentures. Structurally,these are identical in the sense that the initial principal plus accumulated interest is returned in one shot at maturity. Typically,in the case of zero-coupon bonds,we invest an odd sum today and receive a round sum at maturity. However,in the case of a cumulative interest debenture,we often invest a round sum today and are repaid in the form of an odd sum at maturity.
Traders refer to such securities as zeroes. They are also known as deep discount bonds. In general,discount bond is used to describe plain-vanilla bonds,which are trading below their face value. The phrase deep discount,however,usually connotes a zero-coupon security. Such securities,unlike plain vanilla bonds,can never trade at a premium prior to maturity. That is,they are always traded at a price that is lower than their face value prior to maturity,and their price tends towards their face value as the security approaches maturity. Thus,an investor who buys such a security and holds it till maturity is always assured of capital gain.
However,an investor who trades in the security prior to maturity may experience a capital gain or a capital loss. This is because the market yields may increase or decrease after such bonds are acquired and,consequently,a bondholder who sells prior to maturity faces the spectre of both capital gains as well as losses. One of the key features of such bonds is that they are totally bereft of re-investment risk. What exactly is re-investment risk? When we make an investment in a security that makes periodic payouts prior to maturity,the effective compounded rate of return that we can be said to have earned over the holding period,is a function of the rate of interest at which intermediate cash flows are reinvested.
For instance,the yield to maturity (YTM) of a plain-vanilla bond is calculated under the assumption that all intermediate coupon payments are reinvested at the market yield,that is,prevailing at the outset. Thus,there is always the risk that the actual rate of interest at which an intermediate cash flow is reinvested may be lower than the rate that was anticipated earlier. This risk is termed as reinvestment risk. In the case of zero-coupon bonds,since there are no intermediate cash flows,there is no such risk.
Another important characteristic of such securities is that their duration is equal to their time to maturity. Duration,in the case of plain-vanilla bonds,may be perceived as the effective maturity or the weighted average maturity of the cash flows. A plain-vanilla bond is a essentially a portfolio of zero-coupon bonds. That is,such bonds may be perceived as a basket of cash flows spaced equally apart,where each cash flow may be viewed as a zero-coupon security.
For instance,a 10-year bond will pay 21 cash flows prior to maturity,where the first 20 payments will be coupon interest,while the last will be a principal repayment. The first coupon payment may be viewed as a zero-coupon bond with six months to maturity,and the second as a zero-coupon security with one year to maturity. The last cash flow is a sum of two cash flows,coupon plus principal,and is,obviously,a security with a maturity equal to the initial term to maturity of the bond.
Thus,when we say that a coupon paying bond has 10 years to maturity,we are taking cognizance of the term to maturity of only the final cash flow. The average or effective maturity will obviously be less than 10 years,since the maturities of the component cash flows range from as short a period as six months to as long a period as 120 months. Macaulay termed the effective average maturity of a bond as its duration. Duration is an important statistic for measuring the interest-rate sensitivity of a bond. Interest rate sensitivity of a fixed-income security is directly proportional to its duration and not its term till maturity. The beauty of a zero-coupon bond is that since there is only a single cash flow emanating from it,there is no difference between its stated term to maturity and its effective term to maturity.
Bond traders implement what are termed as immunisation strategies,which are designed to protect portfolios of bonds from interest rate risk. One of the required conditions is that the investment horizon of the holder should be equated to the duration of the bonds. The reason why zero coupon bonds are attractive from this standpoint is that in their case,all we have to do is to identify a security whose term to maturity equals our investment horizon,since there is no difference between the duration,and the term to maturity,for such securities.
The writer is the author of Fundamentals of Financial Instruments,published by WILEY,India