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Relationships Influencing the Price of Zero-Coupon Bonds
Zero-coupon bond prices are affected by the quality of the bonds, period of maturity, call provision, market rates of interest and yield.
The quality of a zero-coupon bond is important due to the return of:
- The issuers ability to redeem the bonds at maturity
- Depending whether the bondholder is capable of selling the bonds at a higher price than that of its acquisition before maturity date.
A zero-coupon bondholder has more to lose in case of default than a conventional bondholder because the latter receives some interest payments that reduces the principal amount invested in the bond.
The quality of a zero-coupon bond is an imposition under the issuers ability to cancel the bond at maturity. A good quality zero-coupon bond has less risks of default than the speculative low-quality bonds.
Investors are willing to pay more for a good quality zero-coupon bond that is why it is a positive relationship that between quality and price.
Assigned rates by the rating agencies such as Moody?s and Standard & Poor?s are means to take into account to credit quality, but should always be updated of the rates subject to changes in the issuing company?s financial position.
The quality of a zero-coupon bond is also related with its yield. A low-quality zero-coupon bond offers a higher yield than a good-quality zero-coupon bond so as to tempt investors.
The negative side is that investors pay less for a low-quality zero-coupon bond than for a high-quality zero-coupon bond. Then, prices are related with inverse yields.
Prices of zero-coupon bonds are sensitive to the markets interest rates fluctuations. The buying price of zero-coupon bond determines the yield during the active lifetime of the security due that interests are paid only at maturity, and interest accrues at the fixed yield.
If market interest rates raised above the fixed yield of a zero-coupon bond, investors would like to sell their zero-coupon bonds and would reinvest in a bond with a higher yield. This action has the effect of depressing prices of the yet existing zero-coupon bonds in a higher degree than to other type of conventional bonds which pay interest every six months or annually.
Zero-coupon bonds are even more volatile in their prices than fixed-interest –payment conventional bonds because zero-coupon bondholders do not receive an interest payment until of the bonds maturity.
Equally, when interest rates drop, zero-coupon bonds are appreciated more than existing conventional bonds due to their fixed yield.
Market factors are also present in prices. A active negotiation zero-coupon bond is priced differently than from a zero-coupon bond with a poor negotiation and with the same maturity and yield.