Question

1. Describe the "zero coupon bond." Indicate how it is issued, valued in the market, and which investor should consider a zero coupon bond.
2. Explain the yield curve and how it reacts to changes in interest rates. Explain why long-term (30-year) bonds generally trade at a higher yield than short-term maturities. Apply the forces of inflation, monetary and fiscal policy, trade deficit, and foreign influences in your explanation.

Answer 1

A izero-coupon ibond iis ia idebt isecurity ithat idoes inot ipay iinterest ibut iinstead itrades iat ia ideep idiscount, irendering ia iprofit iat imaturity, iwhen ithe ibond iis iredeemed ifor iits ifull iface ivalue.

Bonds ihave ibeen iaround imuch ibefore ishares iwere iavailable ito iinvestors. iCompanies iused ito iraise ifunds iwith ia iwritten iguarantee iof ithe ipromise ito ipay iit iback iin ifull iwith iinterest. iThis iguarantee iis iknown ias ia ibond. iBonds ican ibe ibroadly iclassified ias iGovernment iBonds iand iCorporate iBonds.

A icoupon iis ia iperiodic iinterest ireceived iby ia ibondholder ifrom ithe itime iof iissuance iof ithe ibond itill imaturity. iZero icoupon ibonds, ialso iknown ias idiscount ibonds, ido inot ipay iany iinterest ito ithe ibondholders. iInstead, iyou iget ia ilarge idiscount ion ithe iface ivalue iof ithe ibond.

1. A izero-coupon ibond iis ia idebt isecurity iinstrument ithat idoes inot ipay iinterest.

2. Zero-coupon ibonds itrade iat ideep idiscounts, ioffering ifull iface ivalue i(par) iprofits iat imaturity.

3. The idifference ibetween ithe ipurchase iprice iof ia izero-coupon ibond iand ithe ipar ivalue, iindicates ithe iinvestor's ireturn.

On imaturity, ithe ibondholder ireceives ithe iface ivalue iof ihis iinvestment. iIn isimple iwords, ithe iinvestor ipurchasing ia izero icoupon ibond iprofits ifrom ithe idifference ibetween ithe ibuying iprice iand ithe iface ivalue, icontrary ito ithe iusual iinterest iincome.

Zero icoupon ibonds ican iwork iwonders, iif iused imeticulously iand iin isync iwith iyour iinvestment igoals. iIn ithe iabsence iof iany iintermittent icoupon ipayments, ithe iyield ito imaturity iof ia izero icoupon ibond iis icalculated ias ibelow:

(Face ivalue/ icurrent imarket iprice)*(1/years ito imaturity) i– i1

i i i i i i i i i i i i i i i i i i i i i i i iZero icoupon ibonds iare isubject ito iinterest irates irisk iif isold iprior ito ithe idate iof imaturity. iThe ivalue iof ithis ibond iis iinversely irelated ito ithe irise iin ithe iinterest irates; iwith irising iin iinterest irates ithere iis ia idecline iin ithe ivalue iof ithese ibonds iin ithe isecondary imarket. iThe isensitivity iof ilong-term izero-coupon ibonds ito iinterest irates iexposes ithem ito iduration irisk. iThis imeans ithat ihigher ia ibond’s iduration, ithe igreater iwill ibe iits isensitivity ito iinterest irate ichanges.

Note: iDuration irisk iis ithe irisk ithat iis iassociated iwith ithe isensitivity iof ia ibond’s iprice ito ione ipercent ichange iin ithe irate iof iinterest.

Long-term izero icoupon ibonds iare igenerally iissued iwith imaturities iof i10 ito i15 iyears. iThere iis ian iinverse irelationship ibetween ithe itime iand ithe imaturity ivalue iof ia izero icoupon ibond. iThe ilonger ithe ilength iuntil ia izero-coupon ibonds imaturity idates ithe iless ithe iinvestor igenerally ihas ito ipay ifor iit. iZero icoupon ibonds iwith ia imaturity iof iless ithan ia iyear ioffer ia ishort-term iinvestment ioption.

Advantages iof iZero iCoupon iBonds

Bonds iare iusually icompared iwith iother ifixed iincome ioptions iby iinvestors ilooking ifor iminimal irisks. iAs icompared ito iother ifixed-income ioptions, ithese ibonds ioffer igood ireturns ion imaturity iwhile ikeeping ithe ioption iof iselling ithem ion ithe isecondary imarket iopen, iif ithe iinterest irates idecline isharply. iAnother iimportant ifeature iof inotified izero icoupon ibonds iis ithat iinvestors ido inot ihave ito ipay iany itax ion iinterest isince ithe ibonds iare iissued iat ia idiscounted iprice iand iredeemed iat iface ivalue. iThey iare ionly isubject ito icapital igains itax.

i i i i i i i i i i i i i i i i i i i i i iAs imentioned iabove, iinvestors iof inotified izero icoupon ibonds iissued iby iNABARD iand iREC iare iliable ito ipay ionly icapital igains itax ion imaturity. iCapital iappreciation iin isuch icases iis ithe idifference ibetween ithe imaturity iprice iand ipurchase iprice iof ithe ibond. iIn icase iof inon-notified izero icoupon ibonds, ithe idifference ibetween imaturity iand ipurchase iprice iis itreated ias iinterest iand itaxed iaccordingly. iLike ithe igrowth imarket, ithe ifixed iincome isecurity imarket ishould ibe iapproached iwith ia iclear iunderstanding iof iyour iinvestment igoals iand ihorizon. iZero icoupon ibonds ican iwork iwonders iif iused imeticulously iand iin isync iwith iyour iinvestment iobjectives.

Note: iApart ifrom iNABARD, ionly ia ifew iGovernment iOrganizations iwith ithe iapproval ifrom ithe iFinance iMinistry iare iauthorized ito iissue izero icoupon ibonds. iApprovals irequire iannual irevalidation iif inot iutilized iduring ithe inotification iyear.

i i i i i i i i i i i i i i i i i i i i i i i i iA iyield icurve iis ia iline ithat iplots iyields i(interest irates) iof ibonds ihaving iequal icredit iquality ibut idiffering imaturity idates. iThe islope iof ithe iyield icurve igives ian iidea iof ifuture iinterest irate ichanges iand ieconomic iactivity. iThere iare ithree imain itypes iof iyield icurve ishapes: inormal i(upward isloping icurve), iinverted i(downward isloping icurve) iand iflat.

1. Yield icurves iplot iinterest irates iof ibonds iof iequal icredit iand idifferent imaturities. i

2. The ithree ikey itypes iof iyield icurves iinclude inormal, iinverted iand iflat. iUpward isloping i(also iknown ias inormal iyield icurves) iis iwhere ilonger-term ibonds ihave ihigher iyields ithan ishort-term iones. i

3. While inormal icurves ipoint ito ieconomic iexpansion, idownward isloping i(inverted) icurves ipoint ito ieconomic irecession. i

4. Yield icurve irates iare ipublished ion ithe iTreasury’s iwebsite ieach itrading iday.

This iyield icurve iis iused ias ia ibenchmark ifor iother idebt iin ithe imarket, isuch ias imortgage irates ior ibank ilending irates, iand iit iis iused ito ipredict ichanges iin ieconomic ioutput iand igrowth. iThe imost ifrequently ireported iyield icurve icompares ithe ithree-month, itwo-year, ifive-year, i10-year iand i30-year iU.S.

Most iinvestors icare iabout ifuture iinterest irates, ibut inone imore ithan ibondholders. iIf iyou iare iconsidering ia ibond ior ibond ifund iinvestment, iyou imust iask iyourself iwhether iyou ithink itreasury iyield iand iinterest irates iwill irise iin ithe ifuture. iIf ithe ianswer iis iyes, iyou iprobably iwant ito iavoid ilong-term imaturity ibonds ior iat ileast ishorten ithe iaverage iduration iof iyour ibond iholdings; ior iplan ito iweather ithe iensuing iprice idecline iby iholding iyour ibonds iand icollecting ithe ipar ivalue iwhen ithey imature

i i i i i i i i i i i i i i iIn ithe iUnited iStates, ithe iTreasury iyield icurve i(or iterm istructure) iis ithe ifirst imover iof iall idomestic iinterest irates iand ian iinfluential ifactor iin isetting iglobal irates. iInterest irates ion iall iother idomestic ibond icategories irise iand ifall iwith iTreasuries, iwhich iare ithe idebt isecurities iissued iby ithe iU.S. igovernment. iTo iattract iinvestors, iany ibond ior idebt isecurity ithat icontains igreater irisk ithan ithat iof ia isimilar iTreasury ibond imust ioffer ia ihigher iyield. iFor iexample, ithe i30-year imortgage irate ihistorically iruns i1% ito i2% iabove ithe iyield ion i30-year iTreasury ibonds. i

First, iit ishows inominal iinterest irates. iInflation iwill ierode ithe ivalue iof ifuture icoupon idollars iand iprincipal irepayments; ithe ireal iinterest irate iis ithe ireturn iafter ideducting iinflation. iThe icurve itherefore icombines ianticipated iinflation iand ireal iinterest irates.

Second, ithe iFederal iReserve idirectly imanipulates ionly ithe ishort-term iinterest irate iat ithe ivery istart iof ithe icurve. iThe iFed ihas ithree ipolicy itools, ibut iits ibiggest ihammer iis ithe ifederal ifunds irate, iwhich iis ionly ia ione-day, iovernight irate.

 iThird, ithe irest iof ithe icurve iis idetermined iby isupply iand idemand iin ian iauction iprocess.

Sophisticated iinstitutional ibuyers ihave itheir iyield irequirements iwhich, ialong iwith itheir iappetite ifor igovernment ibonds, idetermine ihow ithey ibid. iBecause ithese ibuyers ihave iinformed iopinions ion iinflation iand iinterest irates, imany iconsider ithe iyield icurve ito ibe ia icrystal iball ithat ialready ioffers ithe ibest iavailable iprediction iof ifuture iinterest irates. iIf iyou ibelieve ithat, iyou ialso iassume ithat ionly iunanticipated ievents i(for iexample, ian iunanticipated iincrease iin iinflation) iwill ishift ithe iyield icurve iup ior idown.

Supply-Related iFactors

Monetary iPolicy

If ithe iFed iwants ito iincrease ithe ifed ifunds irate, iit isupplies imore ishort-term isecurities iin iopen imarket ioperations. iThe iincrease iin ithe isupply iof ishort-term isecurities irestricts ithe imoney iin icirculation isince iborrowers igive imoney ito ithe iFed. iIn iturn, ithis idecrease iin ithe imoney isupply iincreases ithe ishort-term iinterest irate ibecause ithere iis iless imoney iin icirculation i(credit) iavailable ifor iborrowers. iBy iincreasing ithe isupply iof ishort-term isecurities, ithe iFed iis iyanking iup ithe ivery ileft iend iof ithe icurve, iand ithe inearby ishort-term iyields iwill isnap iquickly iin ilockstep.

Can iwe ipredict ifuture ishort-term irates? iWell, ithe iexpectations itheory isays ithat ilong-term irates iembed ia iprediction iof ifuture ishort-term irates. iBut iconsider ithe iactual iDecember iyield icurve iillustrated iabove, iwhich iis inormal ibut ivery isteep. iThe ione-year iyield iis i1.38% iand ithe itwo-year iyield iis i2.06%.

If iyou iwere igoing ito iinvest iwith ia itwo-year itime ihorizon iand iif iinterest irates iwere igoing ito ihold isteady, iyou iwould, iof icourse, ido imuch ibetter ito igo istraight iinto ibuying ithe itwo-year ibond i(which ihas ia imuch ihigher iyield) iinstead iof ibuying ithe ione-year ibond iand irolling iit iover iinto ianother ione-year ibond. iExpectations itheory, ihowever, isays ithe imarket iis ipredicting ian iincrease iin ithe ishort irate. iTherefore, iat ithe iend iof ithe iyear iyou iwill ibe iable ito iroll iover iinto ia imore ifavorable ione-year irate iand ibe ikept iwhole irelative ito ithe itwo-year ibond, imore ior iless. iIn iother iwords, iexpectations itheory isays ithat ia isteep iyield icurve ipredicts ihigher ifuture ishort-term irates.

Fiscal iPolicy

When ithe iU.S. igovernment iruns ia ideficit, iit iborrows imoney iby iissuing ilonger-term iTreasury ibonds ito iinstitutional ilenders. iThe imore ithe igovernment iborrows, ithe imore isupply iof idebt iit iissues. iAt isome ipoint, ias ithe iborrowing iincreases, ithe iU.S. igovernment imust iincrease ithe iinterest irate ito iinduce ifurther ilending.

However, iforeign ilenders iwill ialways ibe ihappy ito ihold ibonds iin ithe iU.S. igovernment: iTreasuries iare ihighly iliquid iand ithe iU.S. ihas inever idefaulted i(it iactually i