Introduction
Historically, corporations raised capital from investors based on a written guarantee, and this written assurance is referred to as a bond. At regular intervals, coupon bonds deliver coupons or interest payments. So, what are zero coupon bonds? As their name implies, Zero-Coupon Bonds do not pay coupons or interest throughout the term but instead return the face value at maturity.
Zero coupon bonds are bonds that don’t produce any interest during the duration of the issue. Instead, investors purchase zero coupon bonds at a substantial discount from the total price of zero coupon bonds, which is the amount they would get when the bond “reaches maturity” or “comes due.”
Numerous zero coupon bonds have maturities of various tenures such as ten, fifteen, or even twenty years. These long-term maturities enable investors to prepare for a long-term objective, like funding a child’s college tuition. With the steep discount, an investor may invest a little money that will rise over a long period.
On the secondary markets, investors may acquire several types of zero coupon bonds issued by various organisations, including the government treasury, companies, and state and local governments.
Because zero coupon bonds do not pay interest until maturity, their values on the secondary market vary more than those of other bonds.
Moreover, investors may still be required to pay federal, state, and local income tax on the “phantom” or imputed interest that accrues annually on zero coupon bonds, even if no payments are made until maturity.
Some investors avoid paying tax on imputed interest by acquiring municipal zero coupon bonds (assuming they reside in the state where the bond was issued) or the rare tax-exempt corporate zero-coupon bonds.
To gain an in-depth understanding of zero-coupon bonds, continue reading below.
The Zero Coupon Bond, commonly known as the discount bond, is acquired at a discount and does not pay fundholders coupons or periodic interest.
During the term, money invested in zero coupon bonds does not accrue interest. At maturity, the yearly returns on the principal amount are included in the face value and given to the investor. Therefore, investors get a lump payment after the term.
Corporate zero coupon bonds and government zero coupon bonds are the two forms of zero coupon bonds.
Let us understand how bonds and zero coupon bonds work.
A bond is a means through which a corporation or government entity raises funds. When bonds are issued, they are purchased by investors, who serve as lenders to the issuing organisation. The investors get a return in the form of semiannual or annual coupon payments for the duration of the bond’s existence. At maturity, the bondholder receives a return equal to the face value of the bond. Investors can acquire a corporate bond for less than its face value when issued at a discount.
Other bonds become zero-coupon once a financial institution removes them from their coupons and reissues them. Because they give the complete payment at maturity, the price of zero coupon bonds fluctuates much more than that of coupon bonds.
For instance, an investor who acquires a bond at a discount of Rs. 920 would get Rs.1000. The investor’s profits or return for keeping the bond is the Rs.80 return + coupon payments received. Not all bonds, however, have coupon payments, and those without coupons are known as zero-coupon bonds. These bonds are issued at a substantial discount and pay back the face amount at maturity. The gap between the sales price and par value indicates the return on investment for the investor. The payout the investor receives equals the capital invested plus the accrued interest earned, compounded semiannually at a set rate.
The rate of return on a zero-coupon bond is attributed, meaning that it is an estimated rate of interest rather than a fixed rate. For instance, a bond with a face value of Rs.20,000 matures in 20 years, and a yield of 5.5% may be acquired for around Rs.6,855. After twenty years, the investor will get 20,000 rupees. The difference between Rs. 20,000 and Rs. 6,855, that is, Rs. 13,145 represents the bond’s compounding interest until maturity. Sometimes, imputed interest is also called “phantom interest.”
Zero Coupon Bonds are ideal for long-term investors who are prepared to get their return in a single sum.
Individuals investing for a particular future event, such as a child’s education or a company, should use zero-coupon funds. This fund is appropriate for investors who want to continue investing without worrying about market fluctuations or trends. In addition, investors seeking portfolio diversification at a low-risk level may purchase a Zero Coupon bond. It will diversify the portfolio and provide a lump amount at a certain period.
The lack of a consistent income makes Zero Coupon Bond funds unattractive to many investors.
Others, however, find it suited for achieving long-term investing goals. It enables investors to receive risk-free interest over an extended period. When the interest rate is high, purchasing Zero-Coupon Bonds might be quite advantageous. Buying tax-free municipal Zero-Coupons is an excellent strategy to avoid paying taxes. This only applies to investors who reside in the state where the bond was issued.
Now that you have an idea about the zero coupon bond, you might be wondering what advantages buying a zero coupon bond brings to the investor.
Advantages of zero coupon bonds
Zero coupon bonds have quite a few benefits to the investors, making them a viable investment option.
Before choosing a Zero Coupon bond as an investment, it is essential to comprehend the advantages of zero coupon bonds.
The advantages of Zero-coupon bonds are listed below:
Other coupon bonds do not let investors get a bond’s cash flow at the same pace as the necessary rate of return on the investment. However, zero coupon bonds eliminate the risk of reinvestment. Zero-coupon bonds do not permit periodic coupon payments; hence, the zero coupon rate of interest is guaranteed to be stable.
Bonds with no coupon payments are an excellent option for investors that favour long-term investments and desire a lump-sum payout. This is due to the guarantee of a set return, provided the investment is held until maturity.
The Zero Coupon bond’s lengthy-time horizon substantially benefits long-term investors. A long-term investment may obtain a set sum without concern about market volatility.
These are some of the most prominent advantages of zero coupon bonds investment, and knowing them would help you judge whether zero coupon bonds are a fit investment for you or not. Along with benefits, there are a few drawbacks that you should be aware of if you plan to invest in zero-coupon bonds.
No investment can be perfect, but even if there is no risk involved, zero-coupon bonds still have drawbacks.
Despite its numerous advantages, the zero coupon bond has a few drawbacks, which are discussed below.
Therefore, the zero-coupon bond prevents a regular cash flow, and this bond will not benefit investors who need steady cash flow.
Zero coupon rate of interest may drop over time owing to market fluctuations. Therefore, investors will constantly be exposed to interest rate risk if they sell before maturity.
Due to the secondary market’s lack of liquidity, the value of this bond has a negative connection with the increase in the interest rate. An increase in the interest rate signifies a fall in the secondary market value of the fund.
Duration risk is a bond’s price sensitivity to a one percentage point fluctuation in the interest rate. The longer the term, the greater its sensitivity to interest rate fluctuations.
These are some of the noticeable drawbacks of investing in zero coupon bonds. Keeping these factors in mind helps investors gain insight into the kind of returns they may expect from such investments.
To calculate the capital gains from investment in zero coupon bonds, it is essential to know how zero coupon bonds are priced.
You might be wondering how the price of a zero coupon bond is calculated. Here are the details based on the zero coupon bonds calculation of price is done:
Zero Coupon Bond Price = M / (1+r)n,
Where M is the bond’s maturity value or face value, r is the needed interest rate, and n is the number of years before maturity.
The formula mentioned above is used to set the pricing of zero coupon bonds and subsequently calculate its face value and other factors surrounding it. Let us look into an example to gain more insight into how this works.
If an investor wants a 6% return on a bond with a par value of Rs.25,000 and a maturity date of three years, they will be willing to pay the following price: Rs.25,000/(1+0.06) = Rs.20,991. If the debtor accepts this price offer, the bond will be issued to the investor for a price of Rs.20,991/Rs25,000 = 84% of its face value.
At maturity, the investor earns Rs.25,000 – Rs.20,991 = Rs.4,009, which corresponds to an annual yield of 6%. The longer the period before the bond matures, the lower the price the investor pays, and vice versa. The first maturities of zero-coupon bonds are typically at least ten years.
These long-term maturities allow investors to plan for long-term objectives like investing in a child’s college education. Due to the bond’s steep discount, an investor may invest a small sum that will rise over time.
Zero-coupon bonds may be issued by the government treasury, state and local governments, and companies, among others. The majority of zero-coupon bonds are traded on the main markets.
Interest payments, or coupons, are the primary distinction between zero-coupon and ordinary bonds. Regular bonds, commonly known as coupon bonds, pay interest during the bond’s life and return the principal at maturity.
Even though a zero-coupon bond does not pay interest but trades at a substantial discount, allowing the investor to realise a profit upon redeeming the bond at maturity for its total face value.
To get a clear understanding of the disparity between these two financial instruments, let us go into further details:
The payment of interest, often known as coupons, differentiates a common bond from a zero-coupon bond.
A conventional bond pays bondholders interest, but a zero-coupon bond does not. Instead, bondholders of zero-coupon bonds get just the face value of the bond at maturity. Regular bonds, commonly known as coupon bonds, pay interest during the bond’s life and return the principal at maturity.
Investors in long-term zero-coupon bonds profit from the difference between the purchase price and the amount received at maturity.
This sum might be significant because zero-coupon bonds are generally acquired at substantial discounts to face value, and this discount typically results in greater long-term returns.
Due to the form of the yield curve, a zero-coupon bond will often provide better returns than a conventional bond of the same duration. Long-term bonds have greater yields than short-term bonds under a regular yield curve. The interest payments for common coupon bonds are due before the maturity date, and thus these payments are comparable to those on smaller, earlier-maturing zero-coupon bonds. Interest payments decrease both the waiting period and the risk, lowering predicted profits.
Zero-coupon bonds are more volatile than regular bonds. Therefore speculators may earn more from projected short-term price fluctuations by investing in them.
When interest rates fall, everything else being equal, the price of a zero-coupon bond will climb more than that of a standard coupon bond. Because the values of government treasury bonds react substantially to changes in interest rates, zero-coupon treasuries are favoured for interest rate speculation.
Additionally, zero-coupon corporate bond prices may be utilised to speculate on the health of the issuing business. Assume that a bankrupt corporation previously issued zero-coupon and coupon bonds maturing in five years. The market value of both bonds would have collapsed, resulting in coupon bonds that pay very high-interest rates compared to their initial price. This establishes a buffer in case the firm goes bankrupt before maturity. The zero-coupon bond lacks this protection, carries a greater risk, and yields more profits if the issuer survives.
Zero-coupon bonds may also appeal to investors who want to leave their descendants a substantial inheritance. If an Rs.2,000 bond is received as a gift, only Rs.2,000 of the annual gift tax exclusion is used. However, once the bond matures, the receiver finally gets a significant amount of more than Rs.2,000. Unfortunately for holders of zero-coupon bonds, some taxes may diminish the efficacy of this method.
Even though they do not pay periodic interest, zero-coupon bonds entail a tax obligation for interest payments in certain countries.
This presents an issue of phantom revenue for bondholders. Finding the funds necessary to pay taxes on unearned income might be challenging. As a result, it is often prudent to store zero-coupon bonds in a tax-deferred retirement account to avoid paying taxes on future income.
All interest on these municipal bonds, including attributed interest on zero-coupon bonds, is exempt from federal taxations, and municipal bonds are often exempt from state and municipal taxes.
Zero-coupon bonds have both benefits and drawbacks. However, various investors may react differently to the characteristics.
This bond is suited for investors with long-term investment objectives, although investors with short-term investment objectives may disagree. Accordingly, investors must determine whether or not to purchase zero-coupon bonds based on their investment objectives.
The above information has hopefully given you a thorough understanding of Zero-Coupon Bonds and their function.
An investor chooses a zero-coupon bond based on several factors, but one of the most important is the assumed maturity interest rate. This equation may be used for zero coupon bonds calculation:
Zero Coupon Bond Price = M / (1+r)n,
Where M is the bond's maturity value or face value, r is the needed interest rate, and n is the number of years before maturity.
Imputed interest, sometimes known as "phantom interest," is a hypothetical interest rate. The bond's imputed interest is subject to income tax. When calculating the attributed interest on treasury bonds, the IRS utilises an accretive technique and has applicable federal rates that provide a minimum interest rate in connection to imputed interest and original issue discount requirements.
Time and the value at maturity of Zero Coupon bonds are negatively correlated. The longer before maturity, the fewer investors must pay for the security. Therefore, the term horizon for Zero Coupon bonds is typically between 10 and 15 years. On the other hand, these bonds with maturities of less than one year are a potential short-term investment.
Investors often compare zero coupon bonds to other fixed-income choices to assess the level of risk. At maturity, the yields on zero coupon bonds are sufficient, and there is always the opportunity to sell them on the secondary market if interest rates decrease sharply.
Since zero coupon bonds are issued at a discount rate and repaid at face value, interest income is not subject to taxes. They are subject solely to capital gains tax.
The fundamental description of these bonds suggests that investors do not get regular interest payments, and it would help if you kept this in mind before choosing them. These are appropriate for those who may need cash for a certain point in the future, such as for their children's education, retirement, or scheduled vacation.
Also, if you are uninterested in monitoring market developments and prefer the convenience of an "invest and forget" approach, you might explore zero coupon bonds. If your portfolio consists mainly of growth assets and you seek diversification, zero-coupon bonds may help you achieve a guaranteed return for a specific period.
These bonds provide substantial savings for longer investment terms and are ideal for long-term investment strategies.
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