When a government or corporate requires funds they raise them through by issuance of bonds. Bonds are usually issued for a specific period at a particular interest rate. A bond is a financial instrument that raises funds through the general public. On the purchase of the bond, the issuer of the bond assures you of payback at the time of termination of the contract period stated in the bond tenure. Usually, corporates issue bonds to bridge financial needs and it is considered the most efficient debt instrument. Bonds are categorized according to convertibility, maturity, coupon rates, etc.
In this article, we will discuss Zero Coupon Bonds which are the most preferred by long-term investors.
Meaning of Zero-Coupon Bonds
Coupon bonds ensure people’s interest at regular intervals. People who opt for long-term investments and want to earn a lump sum at the end of a specific period usually opt for zero-coupon bonds. Zero-Coupon is usually bought at a discounted price and does not pay interest to the investors. Zero coupon bonds are usually termed pure discount bonds or deep discount bonds.
Under this bond, the face value of the bond is repaid at maturity to the investor. Zero coupon bonds can be classified into two types according to their maturity period; long-term zero coupon bonds and short-term zero coupon bonds. Long-term zero-coupon bonds are invested for 10 to 15 years whereas short-term zero-coupon bonds are for less than a year.
Government zero-coupon bonds are issued by the government to raise funds whereas corporate zero-coupon bonds are issued by corporate firms to raise funds.
Features of Zero-Coupon Bonds
As mentioned earlier zero-coupon bonds do not pay interest at regular intervals and are always repaid at par. Let us now look into the salient features of zero-coupon bonds:
- The trade of zero-coupon bonds is at discount and they are redeemed at par. Usually, the difference between the discounted price and the redeeming value is the profit the investors yield from the investment.
- It is the most traded debt security that does not pay intervals at a fixed time.
- The price of the bond fluctuates as they are fully paid at maturity.
- Even though there is no interest paid to the investors, the investors still have to pay taxes that accrue each year in connection with the investment.
- There are different types of zero-coupon bonds available to the investor in the secondary market
- Among all the fixed-income investments zero coupon bonds provide a better rate of return on the investment.
- Any bond can be convertible to zero coupon bonds between the time of purchase and maturity.
Advantages and Disadvantages of Zero-Coupon Bonds
The main reasons why zero-coupon bonds stand out among the other investment options are:
- Long-term investment
For a person looking for a long-term lump-sum maturity investment zero coupon bonds is the best option. There is an assurance of return at the maturity period. A person that looks for investment for meeting their long-term goal after a fixed tenure invests zero coupon bonds.
- Ensured return
There is a surety of repayment of the bond at face value at the time of maturity. The bond is purchased at discount and redeemed at par value at the end of tenure. This difference is usually the yield earned by the investor, which is ensured at the time of purchase.
- No Reinvestment risk
Since there is no payment of periodic coupons during the tenure. There is an assurance of a fixed interest rate on these bonds. This fixture ensures that there is no reinvestment risk while investing in zero-coupon bonds.
Even though the most preferred coupon bond type is zero-coupon bonds there are certain shortcomings regarding the same, like:
- Absence of regular income
As there is no periodic payment of interest in zero coupon bonds the investors do not receive a regular or recurring income from the investment.
- Time Value of money
The value of money might decline due to the fluctuations in the secondary market and the interest rate risk invested in them. this might result in different changes in the bond throughout tenure. the longer the tenure the higher the risk of fluctuations.
Calculation of Price of Zero-Coupon Bonds
The price of the zero-coupon bonds can be calculated annually or semi-annually basis.
- If the price is computed annually the following formula is used:
Price of the bond = Face Value of the Bond/ (1+r) ^n
- If the price is computed semi-annually the formula becomes
Price of the bond= Face Value of the Bond/ (1+r/2) ^n*2
Here r is the rate of interest and n is the tenure for which the bond is purchased.
Let us look into an example for better understanding. A bond of 10000rs face value is purchased at the rate of interest of 5% which matures after 20 years. in this case, the price of the bond calculated annually is 3769 approx.
Zero coupon bonds are interest-free bonds issued to investors looking for a long-term investment option. It is the best debt security that ensures the return on investment at the maturity of the bond. Zero coupon bonds ensure that there is yield received from the investment made in that instrument and protects the investors from the reinvestment risk invested in the secondary market activities.