Zero coupon Bonds

Zero-coupon or discount bonds are debt security instruments bought at steep discounts and mature at their face value without paying interest throughout their term. These bonds offer the total face value at maturity, giving a significant return equivalent to the interest gained over time. Ideal for investors seeking a simple and effective investment strategy, they are straightforward, avoiding the complexity of periodic interest calculations.

Understanding Zero-Coupon Bonds

Imagine Mr. Akash, who plans to buy a sedan in five years. He has Rs 5 lakhs and desires a risk-free investment to appreciate Rs 7 lakhs. He selects a zero-coupon bond, specifically the Rural Electrification Corporation bond (REC), yielding 9% annually, maturing in five years. By investing Rs 4,54,952 today, he anticipates a maturity sum of Rs 7,00,000, achieving his goal of purchasing the sedan. This investment demonstrates zero-coupon bonds’ capacity to serve as both a financing tool and a wealth accumulation method, offering a lump-sum payout instead of regular interest payments, which suits investors like Akash looking for straightforward, long-term returns without interim cash flows.

What is a Zero-Coupon Treasury Bond? 

Zero-coupon treasury bonds are issued by governments or quasi-government bodies (sovereign zero-coupon bonds) that finance public expenditures without periodic interest. Due to their sovereign backing, these bonds are perceived as low-risk with relatively lower yields compared to corporate bonds, catering to investors who prioritize security over high returns. Their straightforward nature and government guarantee make them an attractive option for conservative portfolios.

Pricing a Zero-Coupon Bond

How is the price of a zero-coupon bond calculated? You can calculate the price of zero-coupon bonds using the following formula:

Price of the zero coupon bond = Face Value/1/(1+r) ^n

Where ‘r’ is the implied interest rate and ‘n’ is the period to maturity. 

Face value is the maturity value of the bond.

 If zero coupon bonds are compounded twice a year, then the formula would be: 

Price of the zero coupon bond = Face Value/1/(1+r/2) ^(2n)

If the maturity value of the bond is Rs 25,000 and the interest rate is 6% P.A., and the period is 3 years, our purchase price of the zero coupon bond would be Rs 20,991 using the above formula.  

This is calculated as below:

The price of the zero coupon bond = 25000 / (1+.06) ^ (3) = Rs 20,991

If the market discount rate were to change to 10% P.A., the price of the zero coupon bond

would change as follows:

Price of the zero coupon bond = 25000 / (1+.10) ^ (3) = Rs 18,782.87

In the case of a long-term zero coupon, the discounted price will be even lower. Taking the above example and assuming the period to maturity is seven years:

The price of the bond = 25000/(1+.10)^ (7) = Rs 12, 828.95

In this case, we have the advantage of receiving a higher lump sum payment at the end. This will be equal to Rs 12,171.05. 

Who Should Consider Zero-Coupon Bonds For Investing?

Zero-coupon bonds are ideal for investors aiming for substantial returns accumulated over a long period without the need for current income. These bonds suit individuals planning for future financial needs such as retirement or educational expenses, as they offer a lump-sum payout upon maturity rather than periodic interest payments. This makes zero-coupon bonds particularly appealing for those with long-term investment horizons who prefer not to manage ongoing income streams.

What is the Benefit of a Zero-Coupon Bond?

1. Sensitivity to Interest Rate Changes

Zero-coupon bonds offer significant appreciation potential when market interest rates decline, as typically influenced by RBI policies. This characteristic is particularly pronounced in long-term bonds, which are more reactive to rate cuts. Such bonds are less likely to default than corporate, especially during economic downturns. But long-term government zero coupon bonds will see the maximum appreciation potential. Remember that sovereign or government bond default risk is negligible. But this equation also works in reverse. Were market interest rates to rise, zero coupon bond prices would depreciate more than other corporate bonds. If one were to hold a balanced portfolio with both stocks and bonds, one way to hedge the investment risk of stocks is to buy government zero-coupon bonds.

2. Suitable for Long-Term Investment Goals

Zero coupon bonds are tailored for investors looking to secure a substantial sum after a lengthy period without the necessity for interim income. These bonds, purchasable at a substantial discount, mature at face value, providing a fixed return if held to maturity. This feature makes zero coupon bonds a compelling choice for those who prefer accumulating wealth over receiving regular income streams.

3. Advantageous in Variable Interest Rate Environments

One of the distinct advantages of zero coupon bonds is the absence of reinvestment risk. Since these bonds do not yield periodic interest payments, investors need not worry about reinvesting at potentially lower rates. This is especially beneficial in environments where interest rates are falling, thereby safeguarding the investor’s returns against fluctuation.

4. Predictable Returns

The predictability of zero coupon bonds is a significant draw. Investors can determine the exact yield from the initial investment to maturity, providing a clear financial trajectory. This predictability is ideal for those who prefer investments with minimal uncertainty.

5. Achieving Long-Term Goals with Minimal Initial Outlay

Zero coupon bonds are an economical option for achieving long-term financial aspirations. By investing a smaller initial amount—thanks to their discounted nature—investors can plan for significant future financial needs effectively and predictably.

Zero coupon bonds are an economical option for achieving long-term financial aspirations. By investing a smaller initial amount—thanks to their discounted nature—investors can plan for significant future financial needs, such as retirement or educational expenses, effectively and predictably.

Conclusion

For those who want to invest for long periods without any regular income, zero-coupon bonds are the best form of investment. The yield on the zero-coupon bonds is also taxable at maturity in India. You can easily purchase zero-coupon bonds in the secondary markets in India.

Zero-coupon bonds issued by the government of India are a safer bet even though they have a lower yield than corporate bonds. 

Zero-coupon bonds are suitable for risk-averse investors. They are ideal for those who wish to invest for the long term and earn the return in a lump sum at maturity.

However, if the investment objective is to earn regular income or interest, regular bonds become a better investment choice instead of zero-coupon bonds. Zero-coupon bonds help you diversify both your investment and bond portfolios.

FAQs

Q. What is a zero-coupon bond?

A. A zero-coupon bond is a debt security that does not pay interest (coupons) periodically during its life. Instead, it is issued at a significant discount to its face value, and the investor receives the full face value at maturity.

Q. Does zero-coupon bonds have any reinvestment risk? 

A. No, which is a significant advantage in fluctuating interest rate environments.

Q. Who issues zero-coupon bonds? 

A. Both corporates and governments issue zero-coupon bonds in the market. We can purchase such zero-coupon bonds both in the primary and secondary markets.

Q. How does an investor earn from zero-coupon bonds?

A. Zero-coupon bonds are issued at a discount to their par value. We earn our return from the difference between the purchase price and the maturity value. For instance, suppose the purchase price is Rs 91. The value of the bond at maturity is Rs 100 and our return is Rs 100-Rs 91= Rs 9 on a one-year bond.

Q. What is zero-coupon bond vs non zero-coupon bond?

A. The primary difference between zero-coupon bonds and non-zero-coupon bonds lies in the payment of interest. Zero-coupon bonds do not make any periodic interest payments and are sold at a discount, maturing at their face value.

Q. What is the zero rate of coupon bond?

A. The zero coupon rate or “zero rate” of a coupon bond refers to the yield or interest rate of a zero-coupon bond. This is the rate at which the present value of the bond’s future payments is equal to its current price. Zero-coupon bonds do not pay periodic interest, but are instead purchased at a discount and mature at face value. The yield represents the annualized return the bond will earn if held to maturity.

Q. What is a zero-coupon bond issued by the government?

A. A secure, interest-free government bond maturing at its face value, offering a risk-free investment.

Q. Why do people buy zero coupon bonds?

A. People buy zero coupon bonds for several reasons:

1. Capital Appreciation: These bonds are purchased at a discount and mature at par value, providing capital growth over time.
2. Predictability: They offer a fixed return known in advance, making them a suitable choice for long-term financial goals, like saving for college or retirement.
3. No Reinvestment Risk: Since there are no periodic interest payments, investors don’t have to worry about reinvesting at lower rates.

Disclaimer: Investments in debt securities/ municipal debt securities/ securitised debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully.