Zero Coupon Bond: Meaning, Benefits, How & Who Should Invest

Zero-coupon bonds don’t offer any interest payment, but discounts are given on face value at the time of issue, and the bonds are redeemable at face value on maturity.

As the issue price and the maturity value are fixed, it’s an ideal instrument for investors looking for lump sum investments to meet specific financial goals. The price of these zero-coupon bonds will vary based on the maturity period.

In this article, we will learn in detail about Zero Coupon Bond, its meaning, benefits, disadvantages, taxability and how to invest in them.

What are Zero Coupon Bonds?

As per section 2(48) of the Income-tax Act,1961 (I-T Act)” Zero Coupon Bonds” are the bonds

1. Issued by an infrastructure capital company or infrastructure capital fund or public company or scheduled bank.
2. No payment of benefit is received or receivable before maturity or redemption From the issuing entity (i.e., infrastructure capital company, infrastructure capital fund, public sector company, or scheduled bank.
3. The central government may specify through a notification in official gadget bonds that meet these conditions. As the name suggests, Zero Coupon Bonds don’t offer any coupon rate or interest rate, no interest is to be paid during the investment period of such bonds. Instead, such bonds are issued at discount to face value. The difference between the discounted issue price and the face value – that the investors receive on maturity – is the return for the investors in such bonds.

In India, Zero Coupon Bonds are issued with a maturity of 10-15 years. The time and maturity value of these bonds are negatively correlated. The more the tenure, the less investors will have to pay for it.

Features of Zero Coupon Bonds

The features of Zero Coupon Bonds are as follows:

• These are long-term debt instruments, having a maturity of 10-15 years. You also have zero coupon bonds that are short-term. They are usually in the form of T-Bills issued by the RBI.
• These bonds do not pay any interest to the investors.
• These bonds are issued at a deep discount.
• These bonds are traded on the stock exchanges, and the investor can sell them before maturity.
• The investor gets the face value of the bonds at the time of maturity.
• The investor earns from the difference between the price paid to get the bonds and the price received at the time of the bond’s maturity.

Who Should Invest in Zero-Coupon Bonds?

Before investing in Zero Coupon Bonds, individuals should consider the following points:

• Investment objective: Depending on the investment horizon, investors can invest in long-term zero-coupon bonds having a maturity of 10-15 years. However, if your target maturity is 1 year or less, then T-Bills (they are zero coupon bonds) are also available.
• Specified planning: Investors can invest in zero coupon bonds and allocate them to their respective financial goals such as retirement, child’s education, marriage, etc.
• Diversification of portfolio: Investors preferring to diversify their portfolio get a good option to invest in zero coupon bonds.
• Risk-averse: If you plan to hold zero coupon bonds until maturity, conservative investors can invest in them. However, the safety of the principal is of utmost importance; then, they can opt for T-Bill or fixed deposits.
• Safety: These bonds are issued by government organisations with the Ministry of Finance’s approval or by the RBI. RBI issues these bonds in the form of T-Bills.

Benefits of Zero Coupon Bonds

Following are some of the benefits –

• Fixed return

As the maturity value of Zero Coupon Bonds is fixed and investors get a discount during investment, there is no uncertainty regarding the maturity value of such a bond. So, for an investor, the investment and the return become clear at the time of investment, thus eliminating the risk of uncertainty.

• No equity market risks

As Zero Coupon Bonds are not market-linked instruments, market fluctuations have no impact on the capital invested in such bonds. So, for risk-averse investors and investors looking for fixed-income instruments, 

• No need of splitting investments

As the discount is offered on lump sum investments and the return is also the lump sum maturity value without any risks related to stock markets, an investor needsn’t split his/her lump sum money into smaller parts for systematic investment – like SIP in equity plans – to minimise risks. So, for lump sum investors, Zero Coupon Bonds are among the most suitable instruments for investment.

• No impact of interest rate fluctuations

There is no impact of fluctuations in policy rates during the investment period – especially if the investment is continued till maturity. In the case of buying or selling such bonds on secondary market platforms, the price of bonds may change – favourably, in case of a rate cut and adversely, in case of a hike in the overall interest rate level.

• No reinvestment risks

As Zero Coupon Bonds don’t provide any regular interest, there is no scope for reinvesting the money received regularly. Otherwise, the investors would have faced uncertainty due to fluctuations in interest rates while reinvesting their money, which is also called reinvestment risk.

• Liquidity option

After buying a Zero Coupon Bond at a discount during the issue period, an investor needsn’t wait till maturity to get the return. An investor may sell the bond in the secondary market for an early exit if needed. So, secondary markets provide liquidity options for investors to invest and redeem Zero Coupon Bonds.

• No tax during the investment period

As there is no income during the investment period of Zero Coupon Bonds, investors needn’t pay any tax before redemption. However, you will have to pay taxes on any capital gains that you realise when you sell the bond or when it matures.

Shortcomings of Zero Coupon Bonds

• Lack of regular income

For investors looking for regular income through investments, Zero Coupon Bonds won’t meet their investment needs as such bonds provide lump sum returns equal to the face value only on maturity.

• No reinvestment opportunity

The lack of regular income negates the chance of earning more by reinvesting the interest received during the investment period.

• Secondary market risk

In case an investor wants to exit before maturity, he/she may not get the face value due to a lack of demand while selling the Zero Coupon Bond in the secondary market. So, buying and selling such bonds in secondary markets pose risks related to bond markets for investors.

How to Calculate the Price of Zero Coupon Bonds?

You can calculate the Price of Zero Coupon Bonds both on an annual and semi-annual basis. The formula for calculating the price is as follows:

The price of a Zero Coupon Bond calculated on an annual basis:

Price = Face Value / (1+YTM) T

The price of Zero Coupon Bond calculated on a semi-annual basis:

Price = Face Value / (1+ YTM/2) T*2

Where,
Face Value = Maturity Value of the Bond
YTM = Expected Interest rate
T = No. of years till maturity

Example:

Suppose you have a zero-coupon bond with a face value (FV) of ₹1,000 that matures in 5 years. The current market yield to maturity (YTM) for similar bonds is 6%. We will calculate the price of this bond on both an annual and semi-annual basis.

Annual Compounding:

Price = 1000 / (1 + 0.06)^5
Price = 747.26

The price of the zero-coupon bond with annual compounding is approximately ₹ 747.26.

Semi-Annual Compounding:

Some bonds may use semi-annual compounding. In this case, you’ll need to adjust the YTM and T accordingly. The YTM needs to be divided by 2, and the time to maturity needs to be multiplied by 2:

Adjusted YTM = 0.06 / 2 = 0.03
Adjusted T = 5 years x 2 = 10

Now, we can calculate the price with semi-annual compounding:

Price = 1000 / (1 + 0.03)^10

Price = 744.09

The price of the zero-coupon bond with semi-annual compounding is approximately ₹744.09.

How to Buy Zero Coupon Bonds in India?

Investing via the primary market

• Banks: Individuals can buy government bonds from banks and main dealers who are permitted to trade in government securities. They frequently facilitate purchases both at the initial offering and in the secondary market.
• RBI Retail Direct Portal: The Reserve Bank of India has launched the RBI Retail Direct Portal, which allows ordinary investors to register an account and acquire government securities such as treasury bills and other bonds directly.

Investing via the secondary market

• Open a Demat and Trading Account: A Demat account is essential for trading and investing. If you don’t have one already, open both these accounts through your registered stockbroker.
• KYC Procedures: Make sure that you proceed with the Know Your Customer (KYC) compliance. This step involves the submission of crucial documents such as ID proof, address proof, and bank account particulars.
• Exploring the Market: Research the different government bonds available before investing. Look at their interest rates, maturity periods, and other features to decide which suits your investment goals.
• Consult Your Broker: Contact your broker for advice and details on the bonds available for purchase. Brokers often provide insights and analyses to help you make an informed decision.
• Placing the Order: Log in to your trading account and navigate to the government securities/bonds section. Select the bonds you wish to purchase and place an order specifying the number of units you want to buy.
• Settling your investment/Trades: The bonds will be credited to your demat account once your order is executed. You will receive periodic interest payments in your linked bank account, and upon maturity, the principal amount will be credited back to your bank account.

Essential Things to Know About Zero Coupon Bonds

Investors frequently compare zero-coupon bonds to other fixed-income choices to assess the level of risk. The returns on zero-coupon bonds are favourable upon maturity, and they can always be sold in the secondary market if interest rates experience a sharp decline.

An important aspect of zero-coupon bonds is that the interest income remains tax-free since these bonds are initially issued at a discount and redeemed at face value. They are subject only to capital gains tax.

What is the ideal tenure of a Zero Coupon Bond?

As the time to maturity increases, investors are required to invest less capital. Consequently, Zero Coupon bonds are typically structured with longer-term horizons, typically spanning 10 to 15 years. Conversely, bonds with maturities of less than one year can serve as short-term investment alternatives.

What is Yield to Maturity?

To understand what yield to maturity (YTM) is, you need to revisit the relationship between bond price and yield. The YTM of a bond is basically the overall return you can expect from the bond investment until it matures from the time of subscription.

It means that you do not sell the bond in the secondary market. Instead, you hold the asset till it matures. Thus, the yield to maturity accounts for all the projected future cash inflows till the maturity date, including the interest payouts and the bond value at maturity.

What is the difference between Zero Coupon bonds and Regular Bonds?

How are Zero Coupon Bonds Taxed?

Zero Coupon bonds are taxed depending on whether they are classified as capital assets or not.
If a zero coupon bond is held as a capital asset, it will be subject to capital gain tax when it is sold or redeemed. However, If a zero coupon bond is held as a stock in trade or as a part of a business or profession, the income earned from it will be taxed as business income or professional as the case may be.

When zero coupon bonds are held as Capital assets?

As per section 2(42A) of I-T Act, 1961 if an assessee holds a zero coupon bond for not more than 12 months immediately preceding the date of its transfer, then that will be treated as a short-term capital asset and any gain on sale of it will be treated as Short-term capital gain and if it is held for more than 12 months then it will be treated as a long-term capital asset and gain arising on sale of it will be treated as a long-term capital gain.

As per proviso to section 112(1) of the I-T Act, 1961 the long-term capital gain on zero coupon bond shall be chargeable to tax at 10% without indexation benefits if the gain exceeds more than 1 lakh in the financial year. 

Short-term capital gain on zero coupon bonds is taxable at a normal rate of tax which is determined on the basis of the total taxable income of the taxpayer. 

When zero coupon bonds are held as stock in trade?

When zero coupon bonds are held as stock in trade then they are taxed as income from business or profession and taxed accordingly. 

Conclusion

A Zero Coupon Bond is a fixed-return instrument that helps fulfil a financial goal by making a lump sum investment for a duration similar to that of the financial goal. As the investment amount, maturity amount, and duration of such a bond are clearly defined, no major calculation is needed to calculate the return and hence it’s easier to align a Zero Coupon Bond with a financial goal.  

But, before investing in zero coupon bonds, it’s important to note that it carries some risks, such as the risk of default by the issuer, interest rate risk, and liquidity risk.

Before investing in zero-coupon bonds, investors should carefully consider their risk tolerance and financial goals, and seek professional advice as needed.

Frequently Asked Questions (FAQs)