Zero-coupon bonds are free from re-investment risks

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.

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