Understanding Zero Coupon Bond

What is a Zero Coupon Bond?

A zero coupon bond is a debt security bought at a discount, with no periodic interest payments. There are no periodic returns, and a lump-sum amount is received at maturity. The return is realised as the difference between the purchase price and the face value received at maturity. Investors receive the full amount at the end of the tenure.

Price of zero coupon bonds is calculated by using the following formulae:

• When calculated annually: Price of bond = Face value / (1 + r)^n
• When calculated semi-annually: Price of bond = Face value / (1 + r/2)^(2*n)

Here:

• Face value = bond's maturity value,
• r = rate of return,
• n = number of years until maturity.

Benefits of Zero Coupon Bonds

Both government and corporate zero coupon bonds offer several benefits, such as:

• Fixed Returns: Zero coupon bonds are suitable for investors who prefer long-term investment and a lump-sum earning. Returns on these bonds are fixed if the investments are kept until maturity.
• No Coupon Reinvestment Risk: Because there are no regular interest payments, investors are not exposed to the risk of having to reinvest coupons at lower rates.
• Less Operational Complexity: Zero coupon payments include less operational and administrative work related to interest collection, accounting and reinvestment decisions.

Types of Zero Coupon Bonds

Zero coupon bonds are issued by both private companies and by the government. They are:

Corporate Zero Coupon Bonds

These are the zero coupon bonds issued by private or public-sector companies that do not offer periodic interest. The bonds are issued at a significant discount and redeemed at the face value on maturity. These involve a risk level higher than government zero coupon bonds, as the returns depend on the company's creditworthiness. Many mutual funds incorporate corporate zero-coupon bonds in their fixed income portfolios for added diversification.

Suppose a company issued a bond with a face value of say ₹1,000 and sells it at a price of say ₹700; no yearly interest is paid. The company pays ₹1,000 on maturity. The difference of ₹300 is the investor's return over time.

Government Zero Coupon Bonds

These are debt securities issued by the government that do not pay regular interest. They are issued at a discount and redeemed on maturity. The difference between the issue price and redemption value is the investor's return. For debt mutual funds purchased on or after 1 April 2023, returns are taxed at the investor's applicable income-tax slab rate, regardless of holding period.

In India, Treasury Bills are the closest match to government zero coupon bonds. They are issued below face value and returned at full value over brief tenures of up to 364 days.

Key Takeaways

A zero coupon bond refers to securities purchased by investors at a significant discount to their face value. They do not include periodic returns; the corpus is received at maturity. They are of two types: corporate zero coupon bond and government zero coupon bond. Both are ideal for investors wanting to have a long-term investment and full payment at maturity. They offer a predictable return with no risk of reinvestment and fewer operational complexities.