What are Zero-Coupon Bonds?
Zero-coupon bonds (ZCB), as the name suggests, do not pay any coupon interest payments to the bondholders. These bonds are also known as discount bonds as they are issued at a price lower than the face value (or par value) and are repaid at face value on their maturity dates. The return to the investor would be the difference between the face value of the bond and its purchase price.
For instance, if you purchase a zero-coupon bond having a face value of Rs 20,000 at Rs 18,000, then on its maturity date, you will receive Rs 20,000, with Rs 2,000 being your returns on the bond, on the maturity date of the bond.
How to calculate the Yield-to-Maturity (YTM) of Zero Coupon Bonds
The YTM is the rate of return received if an investor purchases a bond and holds it until maturity. The formula for the calculation of your returns is mentioned below:-
YTM = (FV/PV) ^ (1 / t) – 1
‘FV’ represents the future value of the bond, ‘t’ is the number of compounding periods and ‘PV’ indicates the present value or price of the bond.
Also Check: Government Bonds
Why Invest in Zero-Coupon Bonds
- Compounded Growth: As zero-coupon bonds are issued at a discount and fully redeemed at face value on the maturity date, investors benefit from compounded growth because of no periodic interest payments.
- Predictable Returns: These bonds offer a fixed payout on their maturity dates, thus allowing you to easily align your investments with your financial goals.
- Portfolio Diversification: Including zero-coupon bonds in your investment portfolio can provide stability to it and help in optimising your asset allocation strategy.
- No Reinvestment Risk: Reinvestment risk refers to the possibility of the investor not being able to reinvest coupon payments at the rate equivalent to their current rate of return. As zero-coupon bonds have no periodic interest payments, all returns are received on the maturity date. This eliminates the need for reinvesting the coupon receipts and thus, reduces the reinvestment risk for the bond
Also Read: What are Corporate Bonds
What are the Risks of Investing in Zero-Coupon Bonds
Interest Rate Risk
The market interest rates and bond prices are inversely related to each other. If interest rates rise, the value of the zero-coupon bond may fall. Note that the interest rate risk would be valid only for investors planning to sell their zero-coupon bonds before their maturity dates. Investors can eliminate the interest rate risk by holding these bonds till their maturity dates.
Liquidity Risk
Liquidity risk refers to the risk that an investor may not be able to find enough buyers to sell the bond in the secondary market before its maturity date. As a result, an investor may be forced to sell their zero-coupon bond at a lower price than its face value which reduces overall returns. To reduce this risk, investors should review the bond’s trading volumes in the secondary market before purchasing.
Credit Risk
Credit risk of a zero-coupon bond refers to the possibility of the bond issuer defaulting on its maturity repayments. Before investing, investors should check their credit ratings assigned by CRISIL, ICRA and other SEBI-registered credit rating agencies to evaluate the creditworthiness of these zero-coupon bonds.
Who Should Invest in Zero-Coupon Bonds
- Zero-coupon bonds are ideal for investors who are not looking for periodic interest payments but are instead focusing on receiving a lump-sum payout on a future date.
- Investors in the higher tax slabs can also consider zero-coupon bonds. The returns generated from zero-coupon bonds are derived solely from the capital gains; the returns do not include interest (coupon) income as zero-coupon bonds do not generate interest income. As the long-term capital gains (LTCG) derived from listed bonds are taxed @ 12.5%, zero coupon bonds offer higher tax efficiency than other bond types for investors in the higher tax slabs.