The attractiveness and risks of investing in zero-coupon bonds.

1. Discuss and illustrate the attractiveness and risks of investing in zero-coupon bonds.

Zero-coupon bonds, unlike other regular bonds, are one of the fixed-income securities that generally don’t pay interest. This is illustrated, in that, it generates return at maturity date rather than the regular periodic payment. These bonds do not provide income payment at intervals unlike the other bonds and this has made them unpopular. This trend has discouraged the majority of investors. However, some investors consider investing in the “Zero Coupon bond” as an opportunity to reach their long-term financial achievement or goals in a rather less risky way.

According to, (Choi, Wirjanto, 2007, pp. 116-126) the formula used to calculate zero-coupon bonds is ‘P=M/(1+r’.  P represents the price; M is the maturity level of the bond; r represents the investor’s required annual yield/2 or otherwise (semi-annual yield) and lastly, n is the (number of years until the maturity) *2.

The Corporations and Government issues zero-coupon bonds making these bonds become very popular and very common. However, corporate zero-coupon are very riskier to invest because when the corporate defaults, then the holders of the bond lose more. Surprisingly, Coupon-based bonds pay the regular payment in the form of interest.  Zero-coupon bonds investors profit from the difference of the buying price and face value when the bond hits maturity. (Chance, 1990, pp. 265-274)

Advantages

1. The investors are subjected to capital gains tax, implying that even if there is a sharp fall in the interest rate then investors don’t have to pay any tax on the interest. This is because bonds are issued at a discounted price, that is, they are bought at a fraction of the intended face value. For instance, a $20,000 bond can be purchased at less than half of the amount.
2. If the zero-coupon is issued by a government entity, the interest generated is exempted from the income tax. This increases the earning percentage for investors.

• Long term investors who invest in coupon bonds are issued with maturities of 15-20 years. The longer the length in years of the bond the less the amount the investor has to pay. They become a good investment option for investors who would require future funds like education for their children or retirement.

1. It’s the best investment for those investors who don’t close the market trend or aren’t interested in watching the market trend. These kinds of investors believe in the ‘invest and forget’ program. This kind of investor most likely does not know the existing trend due to illiteracy or ignorance and thus this investment plan favors them.
2. Zero-coupon holds generally fewer risks as compared to other fixed-income securities, and this makes it serve as an option to great investment that can be used to attain long term financial goals. This investment can be used to secure a return for a fixed period and also certainly perfect for long-term investment plans.

Risks involved

1. Zero-coupon bond rates depend entirely on interest rates. Due to the appreciation and depreciation of the interest rates, then the market value of the bond fluctuates about the coupon rates which are higher or lower from current interest rates. the daily price of the bonds fluctuates daily. Investors selling them before maturity receive rather less money than they originally paid for them.
2. The investor must maintain their bond until the maturity date to receive profit. This is noted as to why they have reduced the price of the market by its value of the par. However, other zero-coupon may not be bought from creditworthy entities may not reach maturity for decades.

The figure below shows a $1000 zero-coupon bond of 10 years.

(Waggone,1997, pp.97)

4. Distinguish between offset mortgages and current account mortgages and discuss their relative advantages and disadvantages.
5. Offset mortgages

An offset mortgage is a type of mortgage that incorporates the blending of traditional mortgage with either one or more deposit accounts that are held by the same financial institution. Mortgage balance maybe is duly offset by savings balance that’s in the account. The credit limit or an initial loan together with the rate of interest for any borrowed funds is established by the financial institution. (O’Sullivan,2005, p. 12)

Advantages of offset mortgages

1. Offset mortgages offer the ability to quickly repay the mortgage than with a normal standard plan.
2. It offers tax advantages.

• It allows the lenders to offset both ISAs and current accounts as well as savings against their mortgage.

1. Offset mortgages offer the opportunity to reduce the interest amount that one is supposed to pay.
2. It offers one to have retained access to their offset savings accounts when it’s necessary.

Disadvantages of offset mortgages

1. Most of the interest rates on offset mortgages may be certainly higher compared to the standard repayment plan.
2. Few lenders offer offset mortgages, making choices to be more limited. As a result of this, there may be an offering of rather less competitive rates.

• The mortgage and linked account for savings must have to be with the same provider.

1. The monthly repayments and interest rates will gradually appreciate if when there is withdrawal from the offset savings account.
2. It’s generally more beneficial financially to use the cash savings as compared to the deposit.
3. Current account mortgages

The current account mortgage incorporates both the current account and the mortgage, and this gives a combined balance to pay. There is a monthly repayment over a period depending on one’s choice. The additional funds in the account serve as an overpayment fund indicating one will technically pay off the mortgage quicker. (Begins; Blake; Buchanan, 2009)

Advantages

1. The main advantage is that if one spends less than they earn each month, they’ll tend to quickly overpay the mortgage and this implies they will quickly clear the mortgage.
2. The more savings and the income you have in your account means you will pay less interest.

• For those who are paid regular bonuses, at any particular time they can borrow back all the money or some of the money they have managed to overpay on the mortgage.

1. Every time you take the money out, overdraft increases, meaning you can overpay and underpay without ever being penalized for this.
2. Cheaper Interest charges on all the borrowings and variable rate for the mortgages.

Disadvantages

1. Current account mortgage interest rates tend to be higher than standard mortgages.
2. One needs to have a large income that’s generated into the account each month.in addition to this, they should have spare funds to effectively take care of the monthly

payments.

Reference

Chance, D.M., 1990. Default risk and the duration of zero-coupon bonds. The journal of finance, 45(1), pp.265-274.

Choi, Y. and Wirjanto, T.S., 2007. An analytic approximation formula for pricing zero-coupon bonds. Finance Research Letters, 4(2), pp.116-126.

Waggoner, D.F., 1997. Spline methods for extracting interest rate curves from coupon bond prices. Federal Reserve Bank of Atlanta Working Paper, pp.97-10.

Begins, J.F., Blake, P.A. and Buchanan, N.J., General Electric Capital Corp, 2009. Apparatus and method for facilitating communication for borrowers and investors regarding commercial mortgages. U.S. Patent 7,523,066.

O’Sullivan, O., 2005. Offset Mortgages Popular Elsewhere, but Here?. ABA Banking Journal, 97(8), p.12.