Question

Your client would like to know the differences between zero-coupon bonds and coupon-paying bonds. Which type of bond’s price is more sensitive to interest rate changes? (Explain in details)

Answer 1

Coupon-paying bonds are issued at their face value. They pay periodic interest (usually semi-annual or annual) during the life of the bond. At the bond's maturity, the final coupon payment and the bond's face value are repaid.

However, zero-coupon bonds do not pay periodic coupon payments. They are issued at a discount to their face value, and the face value is repaid at maturity. The difference between the issue price and face value is the implied interest on the bonds.

A zero-coupon bond is more sensitive to interest rate changes. The price of a bond is the present value of its cash flows, the cash flows being the coupon payments and face value. The discount rate used is the YTM of the bonds (the required return for the bond's investors). Thus, a coupon-paying bond is less sensitive to interest rate changes because a higher proportion of its cash flows are received earlier in the bond's life. A zero-coupon bond is more sensitive to interest rate changes because the bond's entire cash flows is received only at the end of the bond's life.