What is a zero coupon yield curve?

The zero coupon rate is the yield, or yield, on a bond for a single cash payment at a given time in the future. This would represent the return on an investment in a zero-coupon bond with a specific term to maturity. The zero-coupon yield curve graphically shows the rates of return on zero-coupon bonds with different maturities. The reason for constructing a zero-coupon yield curve is its use as a basic tool for pricing many fixed-income securities.

A zero-coupon bond pays no interest but carries a discount on its face value. Therefore, the investor receives a payment of the bond's face value at maturity. This face value is the equivalent of the principal invested plus interest over the life of the bond. The bond yield can be calculated based on the discount amount and maturity, and is equivalent to the investment's internal rate of return. You can use a Treasury bond close to maturity as the equivalent of a zero-coupon bond and use the yield on that bond to calculate the yield curve.

At any given time, the interest rate that can be paid on a financial instrument depends on the term of the investment. A yield curve plots the yield on financial instruments, such as bonds that have similar credit and currency risk, but a different time period to maturity, on a graph. The horizontal axis of the chart represents time to maturity and the vertical axis shows yield. A typical yield curve would rise from left to right because yield increases with longer time to maturity.

Bonds with a shorter term to maturity carry less risk for the investor and therefore would have a lower return, and risk and return typically tend to increase as the term to maturity increases. A flat yield curve is possible if the outlook is uncertain. A negative or downward yield curve can occur if investors expect inflation to decline over the long term.

The price of a security at any given time depends on market conditions, including market expectations regarding future movements in interest rates. The zero-coupon yield curve can change with every fluctuation in market sentiment or economic conditions. Changes in the zero-coupon yield curve are useful as a guide to changes that affect the entire market. Therefore, using this basic tool can help investors and analysts understand the effects of these changes on various investments.