Advantages and Disadvantages of Zero-coupon Bonds

The most important advantages of the zero-coupon bonds are the following:

1. they revalue more than the fixed coupon bonds when the rates of interest decline. However, when interest rates go up , prices of zero-coupon bonds generally drop in larger amounts than those of conventional bonds.
2. Investing in zero-coupon bonds requires less capital than other fixed-income securities because they are sold at a deep discount. For example, a buy of 10 conventional bonds at a face value requires a $10,000 disbursement, but nevertheless 10 zero-coupon bonds that are sold at $180 requires a disbursement of only $1800.

The most important disadvantages of the zero-coupon bonds are the following:

1. The consequence of paying taxes over annual accrued (phantom) interests, which are not received but after maturity, creates negative cash flows over the active lifetime of bonds.
2. Zero-coupon bond prices are highly volatile. When the market?s interest rates raise, zero-coupon bond prices drop significantly, resulting in a great loss of capital when the investor sells bonds before its maturity.
   For zero-coupon bondholders there is no benefit in a raise in interest rates because there are no coupon interest to reinvest.
3. Many zero-coupon bonds have call provisions which allows investors to redeem bonds before maturity when the interest rates drop.
4. If an issuer of zero-coupon bond make a default investors suffer the consequences, situation that would not have happened if they had bought conventional bonds because with these last ones they could have received some interest receipts, which could have been reinvested.

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