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.
What are zero coupon bonds?
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.
How is the zero coupon bond price calculated?
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. 1000, 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.
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.
2. Long-term investment
Zero coupon bonds are for you if you want to invest without being much 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.
3. Potential for higher returns
You can often issue zero coupon bonds at a reasonable discount to their face value, meaning you can lower price. When the zero coupon bond reaches maturity, you will receive the total face value, resulting in a higher overall return on investment.
4. 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.
5. 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.
2. 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 they are a longer term investment avenue. This is because such bonds are more sensitive to interest fluctuations or susceptible to duration risk.
The ideal investor for 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 the 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 our website to learn more.
04 July 2023
6 mins read
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