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Zero-coupon bond: Definition & how they work?

Zero-coupon bond: Definition & how they work?

As a beginner investor looking for a long-term investment avenue, chances are you want one that has a low risk and gives assured returns. And if you’ve done your research, you know that bond investments can help with it. Want greater returns than regular bond investments? Consider investing in zero-coupon bonds.

But what are these investments? How do they work? Perhaps more importantly, how will they bring returns? We answer all these questions in this blog.

Zero-coupon bond definition

Unlike regular bonds that pay regular interest to investors for the duration of the investment, zero-coupon bonds do not pay interest to bondholders. Instead, bondholders receive the face value of the bond on maturity. So, you earn returns according to the difference between the buying price and the face value of the bond.

For example, if you purchase a bond at a discounted price of Rs. 2,00,000 with a face value of Rs. 10,00,000 and have a maturity period of ten years. Then, after ten years, the issuer will pay you Rs. 10,00,000. So, here you do not get any interest, but you will make a profit of Rs. 8,00,000 (face value – purchase value) after ten years.

You can purchase these fixed-income securities at a deeply discounted face value. And you can redeem the returns after 10-15 years of maturity. This is why zero-coupon bonds are also known as discounted or accrual bonds.

Where can you get these bonds? Well, various entities, including federal agencies, municipalities, financial institutions, and corporations, issue zero-coupon securities. Some financial institutions may also remove the coupons on existing bond investments, making them zero-coupon bonds.

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How do zero-coupon bonds work?

Zero-coupon bonds get issued at massive discounts or lower prices than their par (or face) values. Investors can, therefore, buy zero-coupon bonds for relatively low prices and receive more when the bond reaches maturity.

Investors can also profit from the interest accrued on a zero-coupon bond. For example, suppose an investor purchases a bond with a face value of Rs. 20,000 for Rs. 6,757. The bond matures in 20 years with a 5.5% yield, and the interest compounds over time. At maturity, the investor receives the entire par value of Rs. 20,000. The difference in prices is the interest accrued, known as “imputed interest.” This is also known as “phantom interest.”

Unlike some other investment instruments, zero-coupon bonds don’t offer regular interest income. Instead, buyers only gain the interest accumulated and paid at the time of maturity.

The interest income made from them is also free from taxation. This is because the zero bond coupons are usually purchased at a discounted rate and then get redeemed at face value. However, they are subject to capital gains tax.

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Zero-coupon bond formula: How to calculate price & yield?

The price is calculated using the formula-

Price = face value of the bond/ ((1+rate of interest) ^maturity period in years)

The rate of interest is also called YTM (yield to maturity)

Let us understand this with an example.

Suppose the face value of a zero bond is Rs. 1,000, the maturity period is ten years, and the yield to maturity is 5%.

The present value of the bond = Rs. 1000/ (1+[5/100]) ^10 = Rs. 613.91

Therefore, to meet the required rate of return, Rs. 613.91 will be the maximum amount you should agree to pay while purchasing the bond.

Zero-coupon bond vs coupon bond

Zero-coupon bonds differ from regular bonds in several ways. For example, regular bonds pay interest during their lifetime and then pay investors the principal amount at maturity. In contrast, zero-coupon bonds do not pay interest during their lifetime. Instead, investors earn a profit along with their principal amount at maturity.

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Types of zero-coupon bonds in India

The three main types of zero-coupon bonds in India are:

  • Treasury Bills (T-Bills): These are short-term zero-coupon securities that the Government of India issues. They are sold at a discount and redeemed at face value on maturity. The fixed tenures for these short-term debt instruments are 91, 182, and 364 days.
  • Zero-coupon government bonds: These bonds are issued by the government with specific objectives. They do not pay regular interest. Investors earn returns through the difference between the issue price and maturity value.
  • Zero-coupon corporate bonds: These bonds are issued by companies. They are sold at a discount and redeemed at full value later. Their returns are higher than government securities. But their risk is also higher.

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Advantages of zero-coupon bonds

  1. Fixed future cash flow

Zero-coupon bonds, meaning zero-coupon securities, provide you with a predictable future cash flow. Since they do not make periodic interest payments, you know exactly how much you will receive at maturity. It can be advantageous for long-term financial planning and meeting specific financial goals.

  1. Long-term investment

Zero-coupon bonds are for you if you want to invest without being too worried about market ups and downs or changes in interest rates. Providing a stable and secure return, these bonds are a good option for a long-term investment.

  1. Potential for higher returns

You can often issue zero-coupon bonds at a reasonable discount to their face value, meaning you can lower the price. When the zero-coupon bond reaches maturity, you will receive the total face value, resulting in a higher overall return on investment.

  1. Reduced reinvestment risk

With traditional bonds that pay periodic coupon payments, you need to consider reinvesting those payments to earn returns. However, with zero-coupon bonds, there is no reinvestment risk since there are no coupon payments to reinvest. It can simplify your investment strategy and reduce the potential impact of fluctuating interest rates.

  1. Diversification

Including zero-coupon bonds in an investment portfolio can add diversification. Their unique characteristics and potential for higher returns than traditional bonds can help balance your portfolio’s overall risk and return profile.

Disadvantages of zero-coupon bonds

  1. Lack of regular income

Unlike regular bonds, zero-coupon bonds do not let investors earn a periodic interest. Instead, they offer a lump sum at maturity. This makes them unsuitable for investors looking for a regular investment return.

  1. Interest rate risk and duration risk

Although bond returns from zero-coupon bonds are fixed, the selling price depends on prevailing interest rates if the bonds are sold before maturity. Therefore, investors looking to sell their bonds in the secondary markets are more susceptible to interest risk. Besides, the risk of the bond price changing is much greater for zero-coupon bonds, given that they are a longer-term investment avenue. This is because such bonds are more sensitive to interest fluctuations or susceptible to duration risk.

Who should invest in zero-coupon bonds?

Since zero-coupon bonds have long investment horizons and offer returns at maturity as a lump sum, they are ideal for investors looking to earn an assured return over the long term. This makes them an ideal investment avenue for investors with long-term financial goals like retirement, marriage, or their children’s education.

Zero-coupon bonds are also ideal for investors who don’t want to be bothered by market trends. This is because the bonds will earn fixed returns on maturity. That said, investors must consider interest rate risk if they want to sell their bonds before the maturity period ends. So, selling bonds before their maturity period will not guarantee returns during an emergency.

Maximize your investment potential with Tata Capital

Zero-coupon bonds can be an important component of your well-diversified investment portfolio. Even if they might not regularly generate income, they can be a reliable investment option if you have long-term financial goals. You can use the advantages of zero-coupon bonds to advance your financial objectives by carefully weighing the related risks and matching them with your investing strategy.

When investing in zero-coupon bonds or any other financial instrument, you need a trustworthy financial partner. That is where we come in. We at Tata Capital Wealth offer a wide range of bespoke investment services to help you meet your financial goals. Registering with us means taking care of your financial needs through our digital platform. You can view and reorganize your investment portfolio, choose from various investment avenues, and receive end-to-end support while investing. Visit Tata Capital Wealth to learn more.

Risks to know before investing in zero-coupon bonds

While zero-coupon bonds offer various advantages, there are also some risks that investors should understand. These bonds do not pay regular interest. Thus, money is received only upon maturity. If you require cash earlier than maturity, you must know that it may be difficult to sell zero-coupon bonds.

Additionally, zero-coupon bonds are sensitive to interest rate changes. Their prices can fall when rates rise. Due to this sensitivity, the risk with long-term bonds is higher. Corporate zero-coupon bonds also have credit risk if the issuer defaults and fails to pay.

Another risk associated with zero-coupon bonds is inflation. Inflation can reduce the real value of returns over time. There is also liquidity risk, as some bonds may not be easy to trade. Investors should match the bond tenure with their financial goals before investing.

Conclusion

Zero-coupon bonds are debt instruments that do not provide regular interest income. They are issued at a price lower than the face value and redeemed at full value on maturity. The difference between the purchase price and maturity value is the return you earn.

In India, common examples of zero-coupon bonds include treasury bills, government zero-coupon bonds, and corporate zero-coupon bonds. Investors who are interested in a fixed return and not a regular income should invest in zero-coupon bonds. However, there are risks, too. You should consider your time horizon and risk appetite before investing in zero-coupon bonds.

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FAQs

Are zero coupon bonds a good investment?

Zero coupon bonds are considered to be suitable investments since they provide a secure future cash flow, a potential for higher returns, and diversification.

What are the benefits of zero bond coupons?

Some benefits of zero bond coupons are their reduced investment risk, a potential for high returns, and diversification to investor portfolios.

What is the interest rate of a zero coupon bond?

Zero coupon bonds do not pay any interest. Instead, they are sold at low prices, and the investor gains a profit at maturity when they receive the par value.

What is the maturity period of a zero coupon bond?

Zero coupon bonds are usually long-term investments. The typical maturity period of a zero coupon bond is usually between 10 and 15 years.

Who can issue zero coupon bonds?

In India zero coupon bonds can be issued by the Reserve Bank of India (RBI), as well as some other government organisations authorised by the Finance Ministry.

What is the definition of a zero-coupon bond?

You can define a zero-coupon bond as a bond that does not pay regular interest. It is issued at a discounted price and redeemed at face value on maturity. The price difference is the investor’s return.

How do you calculate the price and yield of a zero-coupon bond?

To calculate the price of a zero-coupon bond, discount the face value using the expected interest rate and time to maturity. The zero-coupon bond formula to calculate yield is maturity value minus purchase price.

What are the main benefits of zero-coupon bond investments?

Zero-coupon bonds offer fixed and predictable returns. They are useful for long-term goals and require no reinvestment of interest. They are simple to understand since returns are known at the time of purchase.

Are zero-coupon bonds risk-free in India?

Government zero-coupon bonds and treasury bills are considered safe because they are backed by the government. Corporate zero-coupon bonds are not risk-free and carry credit and default risk.

How is zero-coupon bond income taxed in India?

Income from zero-coupon bonds is usually taxed as capital gains. The tax rate depends on the holding period. Some bonds may also be taxed annually as accrued income under income tax rules.

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