2.10.2. Zero Coupon Bonds Flashcards
What is a zero coupon bond?
1) These bonds make no periodic interest payments.
2) They are issued at a deep discount to their face value
3) The face/par value is delivered at maturity
4) A zero = discount bond
Give an example of a Zero coupon Bond.
A 20-year bond that has a par value of $5k is offered for $1k.
What makes Zero coupon bonds attractive to the borrower/issuer?
They are inexpensive in terms of interest payments.
What makes zero coupon bonds attractive to the lender?
They offer greater leverage. Instead of loaning 5K the investor only needs to offer $1k thus freeing up the money for other investments.
Even though zeros do not make interest payments, the IRS treats the discount as interest, and the bondholder will need to pay taxes on this “phantom interest” at his ordinary income rate. Briefly explain with an example.
Duration - 20 year bond Par value - $5K Issue price - $1K Bondholder will have to pay the interest on the discount offered. ($5k-1K)/20 = $200 per year
How do zero coupon bonds eliminate the reinvestment risk?
They lock in the interest rate for the life of the bond. As the coupon is effectively paid at maturity, it is always earning the prevailing interest rate at the time the bond was issued.
Deferred coupon payments also mean that zero coupon bonds offer the disadvantage of having a _______, since the entire investment is at risk until _____.
credit risk, maturity
What are the disadvantages of zero coupon bonds?
1) High credit risk as the entire investment is at risk till maturity.
2) Also, these bonds are offered in the junk bond market by companies that have the highest risk of default.
3) Also, the investors are required to pay the federal income tax on accrued interest, thus resulting in negative cash flow for the bond holder
How intense are the price fluctuations for zero coupon bonds?
The prices fluctuate more wildly with the market interest rates as compared to other bonds.
They can be up to 3 times to those of an interest paying bond and longer the maturity, the greater the volatility.
Price fluctuations can be up to three times those of an interest-paying bond for Zero coupon bonds, and the longer the maturity, the greater the volatility. Why?
With an interest paying bond, the amount of coupon payments subject to interest rate swings gradually declines as the interest rate payments are doled out. With the zero coupon bonds, every dollar is at risk till maturity.
