The ABCs of Zero Coupon Bonds
It was not that long ago that a three-month bond treasury bill paid that kind of interest. For most of American history , the longest bond maturity the US government offered was 30 years. But historically low rates have revived a long-simmering discussion about whether the US should issue bonds with even longer maturities, like 50 or years. Austria sold a so-called century bond earlier this year with a mere 1. Even serial defaulter Argentina sold a year bond in , though those buyers may regret it now.
It may seems like a risky bet to lend money for such a long time, but there are reasons why now is a good time to both issue and—crucially—purchase ultra-long dated debt. The case to issue long-dated bonds when rates are low is straightforward. The US government now has the opportunity to lock-in low rates for a very long time. It is a rare opportunity borrow for cheap and take decades to pay it off at a certain, low interest rate.
This is ideal for funding infrastructure projects that can take many years to pay off. When senior debtors are paid, if there is money left over, it goes to the next category of investors, know as junior or subordinated debtors. These generally are large corporations or business entities. A bond unit investment trust is a fixed portfolio of bond investments that are not traded, but rather held to maturity for a specified amount of time.
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The length of time to maturity is set when the trust is formed and at the end of that, the investor receives his principal back, just as he would if investing in a single bond. Along the way, investors receive interest payments, typically on a monthly basis. This is considered a low-risk investment, though the fees associated with it can eat into the profits. The bond unit investment trusts operate much like a mutual fund in the sense that you are investing in a large group of bonds and not just one.
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Instead, they put their money in a bond unit investment trust and receive that sort of diversity. There are, in fact, a number of types of yield. The terms are important to understand because they are used to compare one bond with another to find out which is the better investment. To calculate the current yield for a bond with a coupon yield of 4. You get a current yield of 4. The current yield has changed. Divide 4. Then multiply the total by You get a new current yield of 4. Note: Price and yield are inversely related. As the price of a bond goes up, its yield goes down, and vice versa. If you buy a new bond at par and hold it to maturity, your current yield when the bond matures will be the same as the coupon yield.
Cash flow of a zero coupon bond. As in this example all coupon periods have an identical coupon rate specified that is paid at regular intervals; the coupon schedule can be summarised in a single coupon stream. Assuming that the interval between two successive coupon payments is exactly 0. Real world term sheet of a zero coupon bond.
The case for a 100-year US government bond
Table 3. Instrument cash flow schedule table in the zero coupon bond example. Redemption cash flow schedule not strictly needed. Instrument cash flow element table in the zero coupon bond example. A zero-coupon bond is the simplest fixed income security. It is an issue of debt, the issuer promising to pay the face value of the debt to the bondholder on the date the bond matures.
There are no coupon payments during the life of the bond, so it is a discount instrument, issued at a price that is below the face or principal amount. The price increases over time until the maturity date, when it reaches the maturity or par value. We have:. Analysts and researchers frequently work in terms of logarithms of yields and prices, or continuously compounded rates. One advantage of this is that it converts the non-linear relationship in 3.
The expression in 3. A good definition of the term structure of interest rates is given in Sundaresan , who states that it:. For example, Figures 3. Each of the curves exhibit peculiarities in their shape, although the most common type of curve is gently upward-sloping, as is the French curve. The UK curve is inverted. We explore further the shape of the yield curve later in this chapter.
US Treasury zero-coupon yield curve in September UK gilt zero-coupon yield curve. Yield source: Bloomberg.
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French OAT zero-coupon yield curve. Gregory Duffee, in Handbook of Economic Forecasting , Denote its time- t price and yield by.
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The yield on a bond can be related to future bond returns in two useful ways. The relation is. The second accounting identity links the current yield to the sum, during the life of the bond, of one-period yields and excess returns:. These conditional expectations are also identities.
They hold regardless of the information set used for conditioning, as long as the set contains the yield y t n. A strip is a zero-coupon bond , that is a bond that makes no coupon payments during its life and has only one cash flow, its redemption payment on maturity. For example a ten-year gilt can be stripped into 21 zero-coupon bonds, comprised of one bond from the principal repayment and twenty from the semi-annual coupons.
see url Coupon payments due in six, twelve, eighteen and so on months from the stripping date would become six, twelve, eighteen and so on month zero-coupon bonds. In Chapter 6 of this book we explained how the prices of such bonds are related to the yield curve derived from conventional bonds.
What is Coupon Bond?
We also illustrated the general rule that if a yield curve is upward sloping positive , the theoretical zero-coupon yield curve will lie above the conventional bond yield curve, while if the conventional curve is inverted, the zero-coupon curve will lie below it. The gilt strips market is a recent development, with trading having commenced only on 8 December Not all gilts are strippable; only stocks designated as being strippable by the BoE and subsequently the DMO may be stripped.
The market began quietly with relatively low volumes of trading. Strips are fully fledged gilts; they remain registered securities and liabilities of HM Government, therefore they have identical credit risk compared to conventional gilts. There is no limit on the amount or proportion of a strippable gilt issue that can be stripped or reconstituted. The Crest system, inherited from CGO, includes a forward input facility for stripping and reconstitution requests to be entered up to one month in advance.
GEMMs will include strips trading as part of their general gilt market making obligations. We have noted that strips are fully-fledged gilts, registered securities and liabilities of the government. It is not possible to remove a strip from Crest and hold it in paper form.