I know the zero-coupon bond does not pay the coupon during the holding period but only sell as a price largely below the par value. It is said that the non-callable zero-coupon bond has higher interest risk. Is that because yield paid by the zero-coupon bond=(par value-selling price)/selling price much higher than the yield of coupon bond with the same maturity. Therefore, the high yield has more interest rate risk since the situation that the market interest rate is lower than the yield paid by bond might happen? This is my understanding but I am not pretty sure about it. Could you give me some help. Thank you.
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3 responses so far ↓
1 financegal27 // Apr 15, 2008
When you purchase a traditional bond you will receive a coupon payment every month/quarter/semi-annual/annual (depending on the bond). This coupon can then be reinvested, if interest rates increase, then the coupon can be invested at that higher rate, so in a way you have some manner to reduce your interest rate risk, but in a zero coupon, you never receive coupon payments, and thus cannot reinvest those dividends at higher rates should rates increase, therefore you have greater chance of losing money due to interest rates rising versus a more traditional coupon paying bond. Now at the same time you can avoid the issues of rates going down. The problem is you get paid based on the prevailing rates, so lets say the rates go up quite a bit while you hold the bond but when it finally matures the rates are lower than when you initially purchased, then you have a problem. More simply, a zero-coupon bond has the important advantage of being free of reinvestment risk, though the downside is that there is no opportunity to enjoy the effects of a rise in market interest rates. Also, such bonds tend to be very sensitive to changes in interest rates, since there are no coupon payments to reduce the impact of interest rate changes. In addition, markets for zero-coupon bonds are relatively illiquid. Under U.S. tax law, the imputed interest on a zero-coupon bond is taxable as it accrues, even though there is no cash flow. The below link does a good job explaining this in more detail.
2 Warren // Apr 15, 2008
A zero coupon implies that you've reinvested annual interest payments at the rate implied in the price at the moment you purchase it. A traditional bond means you've merely bet on the interest rate. So, in effect, a zero coupon means you're doubling up your bet. This creates greater volatility: your investment will rise more than a traditional bond when interest rates fall; fall more when rates rise.
3 Jeff // Apr 15, 2008
When you buy a bond, you are essentially locking in a rate. You know exactly what you are going to get for the life of the bond. You get a better yield on a zero because the issuer has to pay you more yield in lieu of no coupon payments.
Interest rate risk is defined with two componets - price risk and reinvestment risk. Price risk is simply the changes in value of the bond due to current interest rates - if you keep the bond to maturity, this is irrelevant. you buy $10k of a zero for $6,000 - you get $10k at maturity - every time.
Reinvestment risk is the risk that when your bond matures, interest rates may be lower than the bond that just matured and therefore you don't make as much on your investment as you did in the past.
If you don't need the cash flow and hold the bond to maturity, you will get a better yield from a zero. Remember, your yield is locked in when you buy the bond.
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