The ABCs of Zero Coupon Bonds
Fortunately, you don't need a math degree to understand the basic concepts. Here are some simple guidelines for judging the price volatility of your bonds. The price that a bond sells for in the market today is the sum of all future cash flows, discounted in value because they are not available today. A dollar tomorrow is worth less to you than a dollar today. The discount rate used is the rate of interest prevailing in the market for bonds of the same risk and maturity.
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When that interest rate changes, it affects the price of all bonds, but to varying degrees. The reason is that the maturity value of the long-term bond, as well as many of the interest payments that are being paid, are future cash flows that are very distant points in the future.
If interest rates rise, those very distant cash flows of the long-term bond are discounted in value significantly, and the price of the long-term bond falls in the market abruptly. Coupon rates—the periodic interest payment that is paid by the issuer of the bond—also affect bond price volatility. A higher coupon means that more cash in the form of interest payments flows to the investor before maturity than is the case with a lower coupon bond.
What this means is that when interest rates rise and future cash flows are discounted at a higher rate, the lower coupon bond has relatively more cash flow in the distant future, the maturity value of the bond represents a greater portion of the total cash flow, and the bond's value today will fall relatively more. Combining these characteristics produces the riskiest bonds in terms of price volatility: The most price volatile bonds are those with longer maturities and lower coupons. A long-term zero-coupon bond defines the outer boundary for riskiness. Investors who are risk averse should look for bonds and bond mutual funds that have shorter average maturities—less than five years—and should avoid zero-coupon bonds, particularly long-term zero-coupon bonds.
Table 1 indicates just how much bond prices can change when interest rates change. The table shows the percentage change in bond price for a given interest rate change for bonds of different maturities and two different coupon rates. The table is based on the assumption of semiannual interest payments and bonds selling at their maturity face value. Because of the mathematics of the relative change, the gains are always larger than the losses for the same interest rate change.
Both of these interest rate changes are a bit on the high side but not impossible, and the gains and losses are large because the bond maturity is so long.
The ABCs of Zero Coupon Bonds | Clarity Financial Planning
You can see from the table that the lower-coupon bond at the same maturity has greater price volatility. A higher coupon rate for the same maturity would result in smaller but still very significant price changes. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding a bond to maturity an investor will receive the interest payments due, plus his or her original principal, barring default by the issuer.
Investments seeking to achieve higher yields also involve a higher degree of risk. Treasury zero coupon bonds are guaranteed by the federal government as to the payment of principal and interest. However, if you sell a Treasury zero coupon bond prior to maturity, it could be worth more or less than the original price paid.
How Does It Work?
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The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright FMG Suite. We all know the stock market can be unpredictable.
How Does It Work? Price Swings One of the biggest risks of zero coupon bonds is their sensitivity to swings in interest rates. The market value of a bond will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically falls. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price.
Related zero coupon bonds and rising interest rates
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