Zero-Coupon bond: Definition, how it works and how to calculate
Summary
Zero-coupon bonds are bonds that pay no interest payment. In other words, these bonds trade at discount to its face value. When compared to traditional bonds, they come with a higher yield. The investor gains from the difference between the purchase price and the par value of the zero-coupon bond.
Zero coupon bonds are a type of fixed-income investment instrument that do not make regular interest payments during their life unlike traditional bonds. However, it trades at a hefty discount and the investor gets a fixed amount at maturity at full-face value. In other words, zero-coupon bonds are basically bonds that don’t pay any periodic coupons or interests and are comparatively less competitive. You must keep in mind that since these bonds do not mature for years, they are appropriate for long-term goals such as saving for your child’s education.
Zero-coupons are typically issued by federal agencies, municipalities, financial institutions, and corporations. For example, in India, the RBI issues a zero-coupon bond called Treasury bills, or T-bills.
Zero-coupon bonds: What is it about?
Corporations and government bodies raise capital through bonds. Investors purchase these bonds and profit from coupon payments which are made either annually or semi-annually across its lifespan. At the maturity date, the bondholder gets a sum that is equivalent of the bond’s face value. However, the ones that do not come with coupons or interest are named as zero-coupon bonds.
Zero-coupon bonds can be issued from the very beginning. However, the others morph into zero-coupon bonds after the designated institution takes away the coupons and presents them as zero-coupon bonds. Zero-coupon bonds also have a higher chance of price fluctuations.
To help you understand better, we will compare zero-coupon bonds with regular ones.
Regular bonds vs. Zero-coupon bonds: A snapshot
| Parameters | Regular bonds | Zero-coupon bonds |
| Sensitivity | Less sensitive to both interest rates and inflation-related risks | Highly sensitive to interest rates and inflation-related risks |
| Interest payments | Come with regular interest payments | No cash interest payments |
| Tax implications | Regular income tax based on the yearly interest received. | Annual tax liabilities on the imputed interest generated. |
| Yield at maturity | The yield to maturity (YTM) is dictated by the time to maturity, the market price, and the coupon rate. Indicates the total return expected if the bond is held till maturity. | The YTM is dictated by the purchase discount and the time to maturity. |
| Income generation | Regular income generation from coupon payments throughout the bond's life, in addition to the return of the principal on maturity. | No income until maturity. Their return comes primarily from the difference between the face value and the purchase price. |
| Purchase price | Typically sold close to their face value or par value, with overtime interest determined by the coupon rate. | Typically sold at a significant discount to their face value, due to the lack of periodic interest payments and the time value of money. |
How are zero-coupon bond values calculated?
For zero-coupon bonds, investors generate income from the difference between the par value and the purchase price. Here, the interests earned by the bond is referred to as imputed interest, or a projected interest that is not a real or established interest rate.
Let us assume that a bond has a face value of INR 30,000, which comes with a maturity of 20 years and a 5% yield. The investor purchases the bond at INR 11,316. The investor will get INR 30,000 at maturity of the bond. This means that the investor gains from the difference, which is coming at INR 18,684. The amount is basically the automatically compounded interest. So, the more the time it takes for the bond to mature, the less the investor pays for it. Thus, if you have long-term financial goals, you should opt for them. Note that this imputed interest is subject to income tax.
Zero-coupon bond price calculation formula:
Price = Maturity/ the bond’s face value ÷ (1 + rate of interest required)number of years to maturity
Zero-coupon bonds: Why should you purchase them?
- Zero-coupon bonds are obtained at a deep discount to face value.
- There is only a very low chance of default in federally issued zeros.
- If you need access to liquid funds, then zero-coupon bonds can be sold before their maturity date.
- Zero-coupon bonds are the right investment for future, long-term financial goals.
However, they do come with their own set of disadvantages too.
Zero-coupon bonds: What are the cons?
- As mentioned earlier, zero-coupon bonds are extremely sensitive to interest rates and inflation-related risks.
- There is no cash interest during the tenure of the bond.
- You must pay tax due to imputed phantom income.
Zero-coupon bonds: Key to success with professional guidance
Zero-coupon bonds have certain complexities which you need to understand before investing. They are perfect for investors who are looking for long-term interests and diversification of their portfolios with the allocation of bonds. However, the best way is to get expert guidance to fully understand the nuances of zero-coupon bonds along with their risks and advantages. This will help you make informed decisions and empower you to achieve your financial goals on time.
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