Question

What are the advantages & disadvantages of a zero coupon bond?

ABC issued 20 yr bonds you bought 2 years ago. Now they're offing junk bonds and using the proceeds to repurchase stock. Does any of this effect your bonds value?

Answer 1

Advantages of zero coupon bonds:

1. They can be bought at deep discount. The absence of coupon payments makes these available at deep discount since, only capital appreciation is available with these bonds

2. Interest payments are taxable to the bondholders. The absence of interest payments make them attractive to investors in higher tax brackets

Disadvantages of zero coupon bonds:

1. These bonds are subject to a higher interest rate risk. If the interest rate moves in the reverse directions, there can be possible capital losses and the absence of coupons will not bridge the loss.

2. The investors have to do the due diligence before accepting these bonds since they may run the risk of default and also possibility of the bonds being called exists

The offering of junk bonds does affect the bonds value of the bonds that you purchased earlier. When the junk bonds are issued, the credit rating of the bond issuer reduces. This makes the yield on the already bought bonds very high and hence the prices of the bonds you bought 2 years ago will fall and hence your bond value will take a hit.