Zero Coupon Bond Is One

¶ … zero coupon bond is one in which there is no interest component to the bond. The bond only pays when the principle is returned to the holder. The price of the bond, therefore, is lower than the par value. The returns on zero coupon bonds are calculated on the basis of the differential between the price of the bond and its maturity value. The current yield is defined as the annual cash flows divided by the current market price of the bond (Investopedia, 2009).

The relevance of current yield is that it measures the value of the bond if the investor holds it for one year. The total yield of the investment would depend, however, on the selling price. By contrast, the coupon yield is the value of the cash flow divided by the par value. This reflects the return on the investment if it was purchased at par. Yield to maturity is the value of the bond's cash flows (interest and maturity) based on the current purchase price of the bond.

Yield to call is a concept that applies to callable bonds, whereby the yield of the callable bond is calculated on the basis of the expected cash flows until the call date, rather than the maturity date, divided by the current price of the bond. For the bond in question, the coupon yield would be 7%. The current yield, however, would be 4.2%, reflecting the higher price of the bond. The yield to maturity would be the 4.2%, but the yield to call would be based on a two-year time frame.

The yield to call would therefore be based on the two interest payments of 70 each, and assume that the price received is the par value. Thus, the yield to call would be 2.2%. The call value would determine the actual YTC, however, but in this example that is not known. The call value is typically at a premium. The difference between YTM and YTC is this example shows why such a premium is needed in order to attract investors. 3.

When the expected rate of inflation changes, the expectations for future interest rates also change. An increase in inflation will bring an increase in interest rates, all things being equal. In such a situation, bond prices will go down. If the expected rate of inflation drops, bond prices will increase in anticipation of a potential interest rate cut. The intensity of the price change will depend on the maturity of the bond.

Part of the bond's price is determined by its time value, which is the risk of an adverse change in interest rates. Longer bonds have greater interest rate risk, therefore they are subject to more intense changes as a result of changes in the expected inflation rate. One outcome of this is a change in the yield curve. If inflation is expected to drop, bond prices will increase. This will reduce the yields.

Because the long end of the curve has sharper reactions to such changes, it could end up dropping below the front end. This is what is known as an inverted yield curve. It is a predictor of recession because when interest rates drop too quickly, that is.