What is zero coupon bond
Zero Coupon Bond is a type of bond issued to the investors with zero interest rate. The edge of investing in these bond is that they are issued on a value lower than the face value of the bond.
Explanation with an example
Imagine you are given an opportunity to invest in a real estate property. The value of this property is expected to reach Rs. 25 lakh in the next 10 years. Now the owner promises you to sell the land after 10 years if you pay Rs. 15 lakh today.
Thus it is evident that the buyer is purchasing the property for a much lower value that the actual price and the seller is getting a loan without any obligation to pay any interest.
This is a win win situation for both the parties.
Why are zero coupon bonds issued
Zero coupon bonds were started to raise capital without any obligation to pay year on year interest to the investor. The gains to the investors are compensated by providing the bond issue for a price lower than the face value.
The Government of India issues zero coupon bonds from the public to raise capital to run the country. Against the capital raised, they are selling bonds at a cheaper price for the benefit of the investors.
Since these bonds are backed by the Government, they are highly rated bonds (AAA rated) and have a very low to no chance of failing.
Key highlights
- Bonds with zero coupons are issued at a discount and redeemed at face value. On such bonds, no interest is paid at regular intervals before maturity.
- The price at which Zero Coupon Bonds are offered for purchase is substantially lower than the bond’s face value. Thus, offering an investor an advantage to begin their investment at low valuations.
Advantage of zero coupon bond
Guaranteed return
Zero coupon bonds are issued for a rate much lower than the actual face value of the bond. Thus, it is evident that the investor will get the face value once maturity.
The final price and the time when the investor will receive is defined, making it a guaranteed source of return on maturity.
This type of investment can be done when the investor wants to achieve guaranteed returns in the future to meet his obligations. For instance, an investor buys a zero coupon bond for Rs. 80/- with a face value of Rs.160/- for a period of ten years.
The investors in this case are left with no doubt that they will double their income in the next 10 years, irrespective of the market conditions.
Does not depend on the market fluctuations
Imagine investing in equity, the returns constantly depend on the performance of the market and the general economy of the country. One needs to thoroughly time the markets in order to extract the most benefits out of it.
Since the value of the zero coupon bond is already justified, there will be no impact of the market fluctuations on the bond value. The face value of the bond will continue to exist for the per-determined rate.
The advantage is that the investor is getting an opportunity to invest in a value for a much lower price than the actual value of the bond. Thereby assuring the absolute gains on maturity irrespective of the market condition.
Does not hold interest rate risk & credit risk
Regular coupon bonds have a risk related to interest rate and credit rate. This implies that, when a corporate issues a bond against investors money, they promise to pay an interest on it. There can be instances that the RBI increases or decreases the interest rates, thus risking your return. In some cases, the corporate may not be able to return your principal amount, thus risking on the creditworthy of the bond.
The debt provided on the bond needs to meet the obligation of paying timely interest to the investors. There is a considerable higher amount of risk if these regular bonds are issued by a corporate.
Zero coupon bonds, on the other hand, does not come with any risk related to interest or credit. Since the face value of the underlying of the bond is already present at a value higher than the bond value, which makes it evident that on maturity, the investor will get back the face value.
Long term fund security
Zero coupon bonds work on long term basis. Thus, one can ensure that the capital is protected and the returns will be awaiting to the investor on maturity.
These investments are best suited for long term investors who want to exit with a desired and a per-determined future amount. The investor does not need to worry of the market performance.
On maturity, the investor will be rewarded with the face value of the bond.
Sell off in secondary markets with high yields
During the course of time, the investor may feel the urge to exit the investment and not hold it till maturity. To ease these conditions, the bonds are also traded on the stock exchange. Thus, one can easily transfer the bonds to another investor.
As the time passes, the bond yield will tend to increase, and the primary investor is bound to get a price higher than he initially paid.
Meeting future needs
This type of investment works best for investors who need to meet their financial obligations at the definite period of time.
Investing in stock market can be rewarding, but there can be a scenario when you want to sell off your stock to book profit. As a result, the market may heavily correct when you plan to exit, thereby lowering your returns.
These bonds are an alternative to such investors who need to be at-most sure of their returns and plan their future accordingly.
Conclusion
Zero coupon bonds are an extremely good source to invest in, if the investment is a high purpose driven. Imagine you need to invest money for your child’s education. In this case, one is sure that they will need the money when their child turns 18 years old. So the duration is freezed and you needs to exit before that.
Thus, zero coupon bonds ensures you those returns and a specified duration for your current investment. One can also invest in these bonds and Government securities through mutual funds, which is again a great initiative.
Also read this article published by Reserve Bank of India to understand the guidelines to participate in these Government debt securities: Link to article
Also Read: How Do Mortgage Backed Securities Make Money