The difference between a regular bond and a zero-coupon bonds, is that the former pays bondholders interest, while the latter does not issue.
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Zero Coupon Bond (Definition, Formula, Examples, Calculations)
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- What is a Coupon Bond??
Choose a goal Study for class Earn college credit Research colleges Prepare for an exam Improve my grades Homeschool Other Choose a goal Supplementing my in-classroom material Assigning my students material Teacher certification exam prep Professional development Homeschool Other Choose a goal Helping my child with a difficult subject Personal review to better assist my child Improving my child's grades My child is studying for a credit granting exam Just for fun Homeschool Other. Your goal is required. The yield of a zero coupon bond is different than the yield of a normal bond of the same issuer.
The individual coupons are the semi-annual interest payments due on the bond prior to maturity. The residual is the principle payable at maturity. Investment dealers exist to make a profit so the strips or zeros are sold to investors. The dealers obviously make a healthy profit on stripping bonds.
On the other hand, each strip bond is valued using the YTM of a comparable bond, a 5 year bond for a 5 year coupon and a 30 year bond for the 30 year residual.
The sum of the parts is usually worth more than the whole bond was prior to stripping. Taken individually, each of these payments is an obligation of the issuer, in this case, the Government of Canada. Zero Coupon Bond Also known as Pure Discount Bond or Accrual Bond refers to those bonds which are issued at a discount to its Par Value and makes no periodic interest payment unlike a normal coupon bearing Bond.
In other words, its annual implied interest payment is included in its Face Value which is paid at the maturity of such bond. Therefore this Bond is the one where the sole return is the payment of the nominal value on maturity. The difference between the current price of the bond i. These Bonds avoid the risk of Reinvestment of Coupon Bonds as Interest Rates keep changing with the passage of time which impacts the Yield to Maturity of such coupon bearing Bonds.
Since there are no interim cash flows, the investor is assured of a fixed rate of return. Usually, these Bonds are issued for a longer time frame which can be used by a potential investor to align with their life goals such as Marriage, Children Education, and retirement and so on. Thus a smart investor based on their time horizon can invest in different maturity Zero-coupon Bonds by paying a smaller amount initially as Zero-coupon Bonds are issued at deep discounts one can buy more with lesser amount and stagger them as per their career and life goals without getting impacted by the volatility.
Not all Zero-coupon Bonds have a ready secondary market which results in illiquidity. Furthermore, in case of any urgent need funds, it is difficult to liquidate the same without getting a major haircut in value. They have a single cash inflow for the Investor which happens at the maturity and as such these bonds have the greatest Duration which results in Interest Rate Risk.
Further, These are issued with call provisions which allow the issuer of such Bonds to redeem the bonds prior to their maturity at dates and prices which are predetermined at the time of issue of such Bonds.