5 Reasons Why Zero-coupon Bonds Is the Right Investment for You

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Zero-coupon Bonds

Before we talk about the advantage of investing in zero coupon bonds, let us learn about it.

What are Zero Coupon bonds (ZCB)?


Zero-coupon bondsfall in the fixed income security and is a popular option for investors looking to park their money in a safe instrument. This category of bonds does not pay you coupon rate or fixed interest, but it pays you face value or par value at the end date of maturity. They are traded at a deep discount. It is also known as an accrual bond. These bonds need you to have patience and plan long-term goal with zero coupon bonds. The maturity in it is 10, 15, or more years. It can help you achieve your fund need for your children education, marriage, and more.

For instance, suppose the face value of the zero-coupon bond is 10,000 and the maturity period is 10 years. If it is issued at Rs. 8500, the investor will be required to pay initially Rs. 8500. After 10 years, he/she will get Rs. 10,000. The difference amount of Rs. 1500 is the interest or earning for the bondholder for the 10 years term.

If we talk in different currency, a Zero-Coupon Bonds with a face value of $10,000 and a 5.5% yield that matures in 15 years, can be bought for an amount $3800. At the end of 10 years, the bondholder will get $10,000. The difference between $10,000 and $3800 i.e., $6200 represents the interest income that automatically compounds until the Zero-Coupon Bond matures.

So now the question is why should you invest in zero coupon bonds? What benefits you can gain by deciding to invest in zero-coupon bonds?

Below we will try to find out the reasons for it and discuss the pros of zero-coupon bonds.

5 Key Reasons Why Zero-coupon Bonds is the Right Investment for You

Low initial investment

Zero-coupon Bonds is the best option for new investors who are planning to start initially with a low amount of money. The value at the time of investing is generally small since these bonds are traded at a deep discount. These are affordable and a deeply discounted instrument in the financial segment.

Predictable returns

The return in case of Zero-coupon Bonds is the difference between face value/maturity amount and discounted face value at the time of purchase. The return can be evaluated and is thus predictable.

Good option for long-term goals

Every individual has both short-term and long-term goals in life. Since Zero-coupon Bonds have long maturity period generally 10 years and more, it is more suitable and ideal choice to achieve your long-term goals.

Minimal risk

Every instrument come to you with risks. Some have higher risks while a few others have low risks. The risks in Zero-coupon Bonds can be avoided or minimised by choosing to invest in it through verified and renowned issuers in the market.

Liquidity

Zero-coupon Bonds feature liquidity and is known for its easy exit option. These bonds can be easily traded at the existing rates prior to maturity in the secondary market. You can easily buy or sell it.

How do Zero-Coupon Bonds differ from other bonds?

Coupon rate or interest payment is the prime differentiator between a zero-coupon and regular bond. The investment in regular bonds help you earn interest also termed as coupon over the life of the bond along with the repayment of face value at maturity. In a zero-coupon bond you do not earn regular interest. You get the profit that you earn by purchasing the bond at a deep discount at maturity when you as a bondholder redeem the bond for its actual face value.

Who issues Zero Coupon Bonds?

Zero Coupon Bonds are of distinct types. It can be issued by corporations, federal, state, or local governments.

Who should buy Zero Coupon Bonds?

As an investor you should have an idea about the bond you are purchasing or looking to invest. Make a note of the fact that unlike other bonds, Zero-coupon Bonds do not pay you interest at the predefined interval.

The below points will clarify on the type of investors for whom Zero-coupon Bonds can be a right choice:

  • These bonds are good for investors who are planning to invest with the aim of building fund for long term financial goals. For example, to accumulate money for education of your child, buying a property, retirement, etc.
  • Individuals who are willing to add diversity to their investment portfolio. It can help you include you an asset that has a guaranteed return payable at the end of maturity period.
  • Some investors do not follow market trends and believe in forgetting the investment for a certain period of time. Zero Coupon Bonds can be an ideal choice for such investors.

The Tax Treatment Zero Coupon Bonds

  • Based on the Income-tax Act, 1961 provisions, a taxpayer has the choice to make Income-tax payment for long-term capital gains on selling Zero-Coupon Bond either 20% incase of indexation or 10% on difference of purchase and maturity price in case no indexation is done.
  • Zero coupon bonds redemption proceeds do not attract TDS.
  • On sale of bonds when there is short-term capital gain, the gain will be taxable. The tax will be charged at the tax slab rate that is applicable to your income. It will vary between 5% -30% plus cess and surcharge.

Pricing Zero Coupon Bonds

Use the below formula to calculate the price of a zero-coupon bond:

*This formula is to be used when the interest is compounded annually.

Price of a Bond = Face Value/(1+r) n

Here,

  • r refers to the desired interest rate or rate of return
  • face value is the payable maturity amount or face value
  • n refers to the number of years until maturity

Note:

Zero Coupon Bonds in real terms are typically semi-annually compounded and so the formula to be used is given below –

Price of Bond = Face Value/(1+r/2) nx2

Zero-Coupon Bonds Examples

Example 1: Semi-annual Compounding

Rajesh is willing to buy a zero-coupon bond having a face value of Rs. 1,000 with a maturity period of 5 years. The rate of interest applicable on the zero-coupon bond is 5% i.e., compounded semi-annually. What is the price Rajesh will have to pay to buy the above bond today?

Price of the bond = Rs. 1000 / (1+0.05/2)5*2 = Rs. 781.20

Thus, Rajesh will have to pay Rs. 781.20 for the bond.

Example 2: Annual Compounding

Rajesh is willing to buy a zero-coupon bond having a face value of Rs. 1,000 with a maturity period of 5 years. The rate of interest applicable on the zero-coupon bond is 5% i.e., compounded semi-annually. What is the price Rajesh will have to pay to buy the above bond today?

Price of the bond = Rs. 1000 / (1+0.05/)5 = Rs. 783.53

Thus, Rajesh will have to pay Rs. 783.53 for the bond.

Conclusion

Bonds have always been a desirable choice for both the type of investors (retail and institutional). It is a preferred investment avenue in the fixed income category. The excellent features and pros make bonds an ideal choice for most of the investors. Today you can buy bonds online using the online platforms like bondsindia.com and others. You have the hassle-free access to a wide variety of bonds. You can choose the bond you prefer considering your professional and personal investment needs.

If you need a particular amount of money at a specific period, Zero Coupon Bondscan be an excellent choice. Make-up your mind and plan your investment in bonds to avail the advantage of portfolio diversification, capital protection, assured returns, repayment of face value, and more.

Apart from this, if you are interested to know about What are the top reasons for the craze about coupon marketing? then visit our Finance category.