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What are the Risks of Zero-coupon Bonds
Default risks of an issue are directly related to the financial position of the issuer and is of great importance to zero-coupon bondholders because the interest and principal are canceled with a single payment at maturity; and if the issuer is not able to make this single payment, bondholders receive nothing.
With conventional bonds the holder would have received some interest payments during the bonds lifetime period before default. Consequently, the quality of a zero-coupon bond is a quality that guarantees the capacity and ability of the issuer to comply with payments to bondholders at zero-coupon bond maturity. Default risks can be minimized through a selection of high-quality zero-coupon bond issues or government stripped bonds. Risks of interest rates create a greater impact in zero-coupon bonds than in regular-coupon bonds. This increased volatility in zero-coupon bond prices due to changes in interest rates is a factor because the overall amount received by the zero-coupon bondholder is of an only payment at maturity.
On the other hand, for regular interest-bearing bonds is the discounted cash flows of the interest payments and principal at maturity.
With coupon interest-paying bonds, generally, while lesser the coupon rate of the bond, greater the volatility of the price because of changes in the markets interest rates. This explains volatility in prices of the zero-coupon bonds, which do not have coupon payments.
Some zero-coupon bonds are more volatile in their prices than others with similar yielding zero-coupon bonds as a result of a different activity in negotiation, differences in quality, call features, and periods of time to maturity.
When interest rates drop many outstanding bond issues are called, and the zero-coupon bonds are not an exception. Zero-coupon bonds also have call provisions, which is a lesson that many bondholders have to learn the difficult way.
When interest rates decline, zero-coupon bonds with higher yielding are highly appreciated due to the fact that these bonds are locked into an above–market-rate yield.
However, issuers of these bonds are not so enthusiastic in paying above-market rates, and if the bonds have call provisions they would call them. Zero-coupon bonds do not have any reinvestment risk because the yield is determined by the buying price and later locked into the existing lower yields.
If zero-coupon bonds are sold before maturity, there will always be the risk of principal loss due to the extreme volatility of the zero-coupon bonds. Zero-coupon bonds are the most volatile within all the existing bonds.
Besides, when pricing zero-coupon bonds markups are huge, and bond prices vary from dealer to dealer making zero-coupon bonds be expensive when buying and selling in short term periods.