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Let us say you are using a portfolio of bonds to save for a goal and you use YTM of the bonds to decide the amount and period for which you have to invest to reach your goal. If YTM turns out to be lower than what you expected because of the reinvestment being at lower rates, then the accumulated corpus will be lower and you are likely to miss your goal. Similarly, if you are looking to earn a regular income from the coupon interest received on the bonds, and if the bonds are reinvested at lower rates, then the income you earn will come down.

Buying zero-coupon bonds or deep discount bonds, where you buy the bond at a discount to its face value and receive the face value on maturity, is one way to avoid reinvestment risk as here there is no periodic interest payment to invest. Another way is to tie into a higher yield by investing in long-term bonds when you expect lower interest rates in the future. Reinvestment risk can also be managed by choosing the cumulative option in bonds and deposits where the periodic interest income is reinvested in the same bond or deposit and earns the same rate of interest as the original investment.

On maturity of the investment, the principal and the accumulated interest is paid to the investor. If you are looking to earn regular income from your bond portfolio, then a laddered bond portfolio can reduce the impact of reinvestment risk. To implement this strategy, you invest the same amount of money in bonds that are maturing at different intervals.

In effect, you have tied in to the interest rate prevalent in the market now and know with certainty the income you will receive for the next few years depending upon the number of steps years you have created.

Characteristics of Zero Coupon Municipal Bonds

Each year, one set of bonds will mature and you have the money you need to use for your needs or to invest in a new step at the top of the ladder. Compared with an otherwise identical amortizing security, a zero-coupon bond will most likely have :. Less reinvestment risk : An amortizing security is exposed to reinvestment risk since it receives periodic payments of both interest and principal that must be reinvested ; while a zero-coupon bond has no reinvestment risk since no cash flows are received that must be reinvested before maturity.

More interest rate risk : Because zero-coupon bonds do not have periodic cash flows, they have higher interest rate risk for a given maturity and a given change in market yields.

Exploring Yield vs Price

Two amortizing bonds have the same maturity date and same yield to maturity. The reinvestment risk for an investor holding the bonds to maturity is greatest for the bond that is :. Reinvestment risk refers to the risk that interest rates will decline causing the future income expected from reinvesting coupon payments to decline. The higher the coupon being paid, the greater the reinvestment risk. Because the two amortizing bonds have the same maturity date and the same yield to maturity, the bond selling at a premium must have a higher coupon rate and a higher amount requiring reinvestment and thus higher reinvestment risk.

An investor fears that economic conditions will worsen and the market prices of her portfolio of investment-grade corporate bonds will decrease more than her portfolio of government bonds. A is not correct. B is not correct. Default risk is the risk that the issuer not making timely interest and principal payments as promised. C is the correct answer.

Credit spread risk is the risk that the yield required in the market for a given rating can increase even while the yield on the Treasury security of similar maturity remains unchanged. Thus the investor is concerned about credit spread risk. For an A- rated corporate bond that has deteriorating fundamentals, but is expected to remain investment grade, the greatest risk is most likely :.

Credit spread risk is correct since the bond is expected to see a widening of spreads as a result of deteriorating fundamentals and a potential downgrade but still remaining investment grade. What risk does the bid-ask spread most closely measure :. A is correct.

The One-Minute Guide to Zero Coupon Bonds

Liquidity risk is the risk that the investor will have to sell a bond below its indicated value. The size of the spread between the bid price and the ask price is the primary measure of liquidity of the issue.

If trading activity in a particular security declines, the bid-ask spread will widen, and the issue is considered less liquid. All else equal , an increase in expected yield volatility is most likely to cause the price of a :. An increase in expected yield volatility increases the values of both put options and call options.

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Note here the call option is retained by the issuer. Note here the put option is owned by the bond holder. Therefore, an increase in expected yield volatility will cause the price of a callable price to decrease and a putable price to increase. A portfolio of option-free bonds is least likely to be exposed to :. Volatility risk is present for fixed-income securities that have embedded options. Changes in interest rate volatility affect the value of the embedded options and thus affect the values of securities with embedded options.

By definition, option-free bonds are not affected by volatility risk. The greater the number of years a zero coupon bond has until maturity, the less you have to pay for it. Zero coupon bonds allow investors to invest a modest amount of money today and know exactly how much money they will receive on a specified future date.

Zero coupon municipal bonds provide investors with the opportunity to lock in a particular rate of return, without having to worry about reinvestment risk or interest rates in the future.

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  • Investors in securities that pay interest semiannually may not always achieve a total realized compounded yield equal to the quoted yield to maturity they expected when they purchased their holdings. Depending on future prevailing interest rates, their interest payments may be reinvested in lower or higher yielding vehicles. There are zero coupon municipal bonds available with maturities ranging from one to 40 years, with the majority of these bonds having maturities between eight and 20 years.