Bonds provide a predictable and regular flow of income. Moreover, they add an element of stability to any portfolio by diversifying it. While most bonds offer interest once/twice a year to maintain the fixed income provided, there are certain types that do not make coupon payments. These are known as zero-coupon bonds.
Zero-coupon bonds are debt security instruments that allow investors to earn returns from differential rates of bonds at the time of sale. This makes zero-coupon securities one of the preferred investment avenues for those with a longer horizon and in pursuit of long-term gains.
Read on to know more about zero coupon bonds’ meaning, how they work, and steps to purchase them.
A coupon in bonds means the interest payable by the issuer of a bond. Here, the zero-coupon bond is an instrument that offers no interest. Investors can buy these stocks at a discounted rate as compared to the face value.
At the time of the bond’s maturity, the issuer pays the investor its face value. Hence, individuals can earn returns based on the difference in the value of the bond at the time of buying and selling it.
These bonds come with a maturity period that ranges from 5-15 years, suitable for medium to long-term investors
The zero-coupon bond interest rate is nil, i.e., they do not offer any interest earnings. The only default risk if the issue fails to repay principal at maturity.
When an investor chooses to invest in these bonds he should choose companies with higher credit ratings , which will help him mitigate his risk
Market and interest rate fluctuations do not directly impact the returns earned on zero-coupon bonds. Hence, you can rest assured of earning fixed returns on these bonds, at the time of maturity.
As these bonds do not accrue interest, and are redeemed at face value, you do not have to pay any tax until maturity. However, you will have to pay taxes based on your capital gains on maturity.
You can calculate your zero-coupon bond’s price using the Yield-to-Maturity (YTM) formula. Here is the formula for calculating the prices of these bonds:
Current Value of a Zero-Coupon Bond = (Face value /(1+YTM)^n) – 1
Here,
Face value: Price at which the bond is sold
n: Tenor’s duration in years
To find the value for ‘YTM’:
Yield to Maturity = [Annual Interest + {(FV-Price)/Maturity}] / [(FV+Price)/2]
Where,
Price: Current market value
FV: Face value
Maturity: Number of years until the bond matures
To buy zero-coupon bonds, you need to follow these simple steps:
Own an active Demat account with a registered depository participant
Choose the issuer from whom you wish to purchase zero-coupon bonds
Place an order for your preferred bond by making payment for it
Once the transaction is successful, the bonds will reflect in your Demat account
For investors with a fixed long-term goal, zero-coupon bonds may be a viable instrument. However, if your primary financial objective is wealth creation in the short term, you may find other market-linked investment tools more attractive.
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Reviewer
Yes, zero-coupon bonds in India are considered a safer investment option since they do not offer interest. Hence, there is no risk of default in payment or interest rate fluctuation. They are only exposed to principal repayment default risk. As discussed earlier an investor should choose investors who have a high credit rating to safeguard their investment in ZCB.
You must take into account the risk and reward factors, along with other elements, to determine the right amount to invest in this type of bond.
The maturity period for medium/long-term investment in zero-coupon bonds ranges from 5-15 years.
Some financial institutions strip regular coupon bonds of interest and convert them into zero coupon bonds.