Duration of Zero Coupon Bond and Risk of Default
The duration of zero coupon bond and the risk of default with the bond are closely linked. The longer the duration of a bond is the higher the risk of a default as well with many bonds. This risk correlation is the reason that bonds with a longer duration have a higher rate attached. Short term government bonds usually offer the lowest rates while bonds with a 30 year maturity have higher rates and potential yields. There is an inverse relationship between bond prices and interest rates, and a longer duration for the bond means higher interest rate risks. Interest rate risks are not the only risks that are linked to the bond duration, there are other risks that are a factor as well.
The duration of zero coupon bond will determine the risk of any possible changes in the company makeup. If the bond has 30 year duration then there could be significant changes in the operation and personnel of the business during this time. Some companies are closely associated with the company creator or CEO and if these key employees resign or retire in the future the value of the company could be substantially changed. These changes could cause the issuing company to see a decline in revenue received and increase the risk of a default on the bond. When the duration of zero coupon municipal bonds or this type of bond from other issuers is short it is much easier to research the underlying municipal entity or company and to get accurate and up to date research.
One risk that increases with the duration of zero coupon bond is the risk that markets will change over time and these changes will affect the entity or company issuing the bond. A corporate bond from BP that has a duration of 30 years could involve the risk of a total loss. There is always the possibility that the fossil fuels recovered by BP will become obsolete if everyone switches to alternative energy sources. The likelihood of this is probably slim but increases with every year until the bond matures. Zero coupon bonds that stretch out for decades could experience substantial market changes that can lead to a default on the bond.
The risk of default and the duration of zero coupon bond are just two of the factors that any investor will need to examine. Thorough research is needed to ensure that the duration, risk level, price, type, and quality of any potential bond is closely evaluated. This is true even when dealing with vanilla bonds, which are called this because the bonds are not unusual or remarkable in any way. Once a zero bond is purchased then your gains are locked in as long as the bond is not defaulted on, but if a default occurs an investor could lose some or all of the investment capital. Every investor is different, and some will choose long duration bonds for the higher yield because they are willing to take higher risks. Other investors will determine that the link between duration and default risk with a bond is too strong and will choose other investment options instead.