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What are Zero-coupon Bonds?

Writer # Indiabonds | November 19, 2022

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Zero-coupon bonds, also known as discount bonds, are debt securities that investors obtain at steep discounts on the face value of the bond. This type of bond does not pay any interest during its lifetime. Rather, zero-coupon bonds release the returns at maturity in the form of a lump sum, which is the full face value of the bond. Continue reading to learn more about zero-coupon bonds and how they work. 

Understanding Zero-Coupon Bonds

Example: Mr. Akash wants to invest in a sedan after five years. He has savings of about Rs five lakhs, which he can invest today in a zero-coupon bond for a term of five years. He also wants a risk-free investment that will offer value for money.

The money he is looking to invest in the sedan is around Rs seven lakhs. This means that his investment in the zero-coupon bond should make a lump sum payment of Rs seven lakh after five years. 

The Rural Electrification Corporation zero-coupon Bond (RECB) is available at a yield of 9% P.A., with a maturity date of five years from today. Since RECB is a quasi-government corporation, it has low default risk. 

He has to invest an amount of Rs 4,54,952 today to ensure a maturity amount of Rs 7,00,000 by investing in the REC zero-coupon bond at 9% P.A. In this way, Akash can satisfy his dream of driving away in the sedan by investing in the REC zero-coupon bond. You can see the formula for calculating the current price of a zero-coupon bond in the below section.

Zero coupon bonds’ definition is that they are also a financing method. Instead of regular coupons or interest, they pay back the return in the form of a lump sum. Some financial institutions strip regular coupon bonds of interest and convert them into zero coupon bonds.

What is a Zero-Coupon Treasury Bond? 

Bonds are financial securities through which corporations, public bodies, or governments raise funding to meet the deficits in their spending requirements. Zero-coupon bonds issued by governments or quasi-government bodies (sovereign zero-coupon bonds) are called zero-coupon treasury bonds.

Sovereign or government zero-coupon bonds also enjoy low default risk compared to corporate zero-coupon bonds. Because of this feature, they enjoy a higher credit rating. This also means that the yield on such zero-coupon bonds is also correspondingly lower.

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. 

What is the Benefit of a Zero-Coupon Bond?

The question, what is the benefit of zero coupon bonds can be summed up as below:

1. Inverse relation to interest rates

Zero-coupon bonds can appreciate quite greatly when RBI cuts the market interest rates. If you have a portfolio of zero-coupon bonds, you may see appreciation in your profitability. The longer the period for the bond to mature, the greater the price appreciation potential. 

The longer-dated bonds respond the most to price changes. This is especially true when the economy is headed toward a recession. In the case of corporate bonds which pay interest, there is a greater possibility of default due to the recession. 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. Long horizon with a fixed return

Investors can invest in zero coupon bonds if the objective is to invest for the long term and earn a lump sum return. Zero coupon bonds are an ideal investment for those investors who do not have regular income requirements. 

The appreciation in zero coupon bonds can be attractive for such investors as they can buy zero coupon bonds at a deep discount. If the zero coupon bond is held until maturity, investors can earn the return in a lump sum at the end of the period. If regular income is something you’re not looking for, then zero-coupon bonds become a suitable investment option to consider.

3. Low-interest rate risk in a fluctuating interest rate environment

There is no reinvestment risk with zero coupons, as there are no regular interest flows. As there are no interest flows, there is no requirement for reinvestment of interest payments. This can be beneficial in a declining interest rate environment. 

4. Predictable returns 

As the purchase price and the maturity value of the zero-coupon bond are known in advance, you can reliably estimate the return of the zero-coupon bond. If you hold the bond to maturity, you can safely predict the return of the bond in advance. Such bonds are therefore suitable investments for risk-averse investors.

5. Low investments for meeting long-term financial goals

Zero-coupon bonds are deeply discounted bonds that reduce their initial purchase price. If your preference is in receiving a lump sum amount after the maturity of a certain time interval, zero-coupon bonds are ideal investments for you.

Final Words

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

1)  What is a zero-coupon bond?

Zero-coupon bonds do not make any annual coupon payments during their lifetime. Investors only receive a lump sum at maturity.

2)  Does zero-coupon bonds have any reinvestment risk? 

As zero coupon bonds do not pay any periodic interest, there is no reinvestment risk.

3)  What are the chief types of risks in the case of zero-coupon bonds?

When we buy a zero-coupon bond, we face interest rate risk due to fluctuations in market interest rates. We also face credit risk that the issuer of the bond may default and the liquidity risk that we don’t receive a fair valuation for the bond at the time of selling.

4)  Who issues zero-coupon bonds? 

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.

5) How does an investor earn from zero-coupon bonds?

Zero-coupon bonds are issued at a deep 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.