Unlike regular bonds, zero coupon bonds are one of the fixed-income securities that pay no interest. So, instead of a regular periodic payment, it generates a return at the maturity date. Some investors are not really fond of zero coupon bonds because unlike other fixed income securities, a zero coupon bond doesn’t provide income payments at intervals. So, it may discourage some investors but still, many investors consider “zero coupon bond” an opportunity to meet the long-term financial goals in a less risky way.
Let’s find out more about zero coupon bonds.
How does it work?
When it comes of calculating the price of a zero-coupon bond, the formula used is as follows:
P = M / (1+r) n
P = Price
M = Maturity Value
r = investor’s required annual yield / 2
n = no. of years until maturity x 2
Let’s assume you want to purchase a zero-coupon bond of Company ABC that has a face value of Rs 50,000 and matures in 3 years. Here with this investment, you would like to earn a 10% interest per year. So, using the above formula you might be willing to pay:
50,000 / (1 + 0.05) 6 = Rs 37,313.43
So, when the maturity date comes, you would get Rs 50,000 and would receive “interest” via the gradual appreciation. But, it is for just 3 years, what if it is of 20 years instead of 3 years. You might only pay:
50,000 / (1 + 0.05) 40 = Rs 7,102.27
Zero-coupon bonds are very common. Government and Corporations issue the zero-coupon bonds. However, the corporate zero-coupon bonds are quite riskier because if the issuer defaults then the bondholder can lose more. One who invest in zero-coupon bonds profits from the difference of buying price and face value he/she gets at maturity. On the other hand, a coupon-based bond pays regular payments in the form of interest.
Advantages of Zero-Coupon Bonds
- The first and foremost benefit of investing in zero-coupon bonds is that investors are only subject to the capital gains tax. So, if there is a sharp fall in the interest rate then investors do not have to pay any tax on interest. It is because the bonds are issued at a discounted price and retrieved at face value.
- The second benefit is specifically for long-term investors. The long-term coupon bonds are issued with maturities of 10 to 15 years. The longer the length of the bond the less the investor has to pay. In compared to other fixed-income securities, zero-coupon bonds hold minimal risks and can work as a great investment option to achieve long-term financial goals.
Risks Involved with Zero-Coupon Bonds
As you know that coupon rates largely depend upon the interest rates, if there is an up or down in the interest rates then the market value of the bond fluctuates depending upon the coupon rates are higher or lower from the current interest rate.
To best illustrate this, let’s take an example.
A Rs 50,000 bond issued with a 5% coupon rate pays Rs 2,500 in interest annually regardless of the current market price of the bond. But, if the interest rate goes up to 7%, the newly issued bonds with a par of Rs 50,000 pay annual interest of Rs 3,500 making the 5% bond less interested in the secondary market.
That’s the case of non-zero coupon based bonds. But, in the case of zero-coupon based bonds, the purchaser must maintain his/her bond until maturity to turn a profit. That explains why they have a reduced market price relative to its par value. This is the reason why zero-coupon bonds are often called discount bonds.
Who Should Invest in Zero Coupon Bonds?
Now it is clear to you that zero-coupon bonds are the definition of the absence of interest payments for investors. So, if you are planning to invest in fixed income security – in zero-coupon bonds then you should consider this option. Zero-coupon bonds can become a good investment option for people who would require funds in the future like children’s education or retirement. It is one of the best investment options for those who are not interested in watching market trends and like to believe in “invest and forget”.
You can also add zero-coupon bonds in your portfolio to add diversify to it. It can help you secure the guaranteed returns for a fixed period of time. A zero-coupon bond is perfect for long-term investment plans.
Hope, this article helped you in a way you expected it to be. Nevertheless, if you have any query or would like to add something up then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.