Zero Coupon Bonds

Zero-coupon bonds are issued at a discount and redeemed at face value, with returns generated solely from the price differential. These bonds are ideal for long-term investors seeking predictable returns. In this guide, you will learn how zero-coupon bonds work, their benefits, risks and how they differ from regular coupon paying bonds.

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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.

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Step 2: Select the Bonds

Step 3: Complete the KYC process

Step 4: Enter bank details

Step 5: Link your demat account

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

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Who issues Zero Coupon Bonds

Zero-coupon bonds are usually issued by corporates, especially those active in the financial sector and infrastructure sector. The Government of India has not issued zero-coupon bonds after 1996.

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, one should invest in bonds only after reviewing their trading volumes in the secondary market.

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.

Also Know: Tax Free Bonds

Zero Coupon Bonds vs Coupon Paying Bonds

Distinction	Zero-Coupon Bonds	Coupon Paying Bonds
Interest Payments	No periodic interest (coupon) payments	Pay periodic interest (usually monthly/quarterly)
Purchase Price	Issued at a discount to face/par value	Either issued at face value/discount/premium of the bond
Return/Yield	The difference between the purchase price and the face value is the return generated on ZCB.	The returns are derived from the coupon payments and any gain/loss of the bond, if redeemed before maturity.
Reinvestment Risk	Reinvestment risk is applicable on the maturity proceeds of ZCB	Reinvestment risk is applicable on both coupon payments (except for cumulative bonds) and maturity proceeds

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How to Buy Bonds through Paisabazaar?

Get up to 13.25% from bonds in 5 simple steps

Step 1: Login to your Paisabazaar account

Step 2: Select the Bonds

Step 3: Complete the KYC process

Step 4: Enter bank details

Step 5: Link your demat account

FAQs

Zero-coupon bonds, also known as discount bonds, do not pay coupon interest payments. These bonds are issued at a discount to their face value and are repaid at face value on their maturity dates.

Zero-coupon bonds are primarily issued by corporates, particularly in the financial and infrastructure sectors. The Government of India has not issued zero-coupon bonds since 1996.

Zero coupon bonds cannot be redeemed before maturity. Investors can sell them in the secondary market before the maturity dates if liquidity is available.

Coupon bonds pay periodic interest to investors during the bond’s tenure, whereas zero-coupon bonds do not pay any coupon interest payments and provide returns through the difference between the purchase price and the face value received at maturity.

Investors earn returns from the difference between the purchase price and the face value received at maturity.