What Is a Zero-Coupon Bond?
A zero coupon bond, sometimes referred to as a deep discount bond, is just as popular as a regular bond. While they do not offer any interest payments, they are traded at a substantial discount on the face value. As a result, investors do not receive any fixed income or fixed returns; instead, zero coupon instruments pay a lump sum to investors as a principal based on the bond’s current face value.
So, why is the lower purchase price of a zero coupon bond an attractive feature for investors? Well, this is where the time value of money comes into play. An investor will buy a zero coupon bond with the guarantee of receiving an appreciated return in the future. A zero coupon bond’s higher future value offers a significant advantage and makes them an ideal long-term investment option.
The lower purchase price of zero coupon bonds is a direct result of the imputed interest offered by the instrument. The maturity value on zero coupon bonds is the purchase price plus the interest accrued, compounded annually or semi-annually. The imputed interest added to the purchase price gives yield to maturity of the zero coupon bond, which the investor receives automatically in the future as a phantom income.
The long time horizon of zero coupon bonds is a major advantage for investors. With long-term maturity dates, bond buyers do not need to worry about the short term.
How is the price of a Zero Coupon Bond Calculated?
The formula for calculating the price of a zero coupon bond is:
Price of bond = (Face value)/(1+r)^n,
where the face value is the bond’s maturity value, r is the imputed interest rate, and n is the number of years to maturity.
If the rate of interest is compounded semi-annually, then the formula changes to:
The bond purchase price = (Face value)/(1+r/2)^2n
In the above case, since the interest rate gets compounded semi-annually, the number of years until maturity is doubled to account for the total number of periods in which the bond compounds.
Most zero coupon bonds are compounded either annually or semi-annually. As evident from the above formulae, the longer the maturity period, the lower the price an investor pays to purchase the bond.
Suitable Tenure for Zero Bond Coupon
Zero coupon bonds are ideal for long-term investors who want a substantial fixed return on maturity. They have long-term maturity dates that directly correlate with the maturity value and an inverse correlation with the price. Longer the maturity period, the higher the face value on maturity and the lower the bond price.
Typical tenures of zero coupon bonds are between 10 and 15 years.
Who Should Consider Zero-Coupon Bonds For Investing?
Zero coupon bonds are ideal long-term investment vehicles. They offer a long time horizon till the bond matures, are immune to market & interest rate fluctuations, and pay a lump sum on maturity. Since coupon bonds pay a substantial maturity amount, they are great for anyone looking for long-term financial solutions, such as money for their child’s college education or significant capital gains for their business.
Their immunity to market fluctuations and imputed interest make zero-coupon bonds great for anyone looking to make a significant one-time investment and not worry about market ups & downs.
A zero coupon bond is also a great way to diversify one’s investment portfolio. A diverse portfolio is a great way to reduce market and default risk.
Features of Zero-Coupon Bond
The most prominent feature of zero coupon bonds is the lack of periodic coupon payments. Instead, the interest rate associated with these bonds is imputed to reduce the buying price of the bond concerning its face value. This is why they are also referred to as deep discount bonds.
Unlike other coupon bonds, there are no fixed interest incomes with these zero coupon bonds.
- On maturity, investors receive the entire par value of the bond, and the difference between that value and the purchase price is the investor’s return, which is the accrued interest through the entire tenure.
The lack of regular interest payments makes these bonds immune to reinvestment risk. However, zero coupon bonds are subject to interest rate risk as these bonds’ interest rates can fluctuate per market conditions.
Advantages of Zero-Coupon Bonds
- Zero coupon bonds assure a fixed amount of money on maturity. They are a reliable & secure source of fixed returns for investors and an excellent choice for portfolio diversification. A zero coupon bond is immune to short-term market ups & downs.
- They do not offer any fixed income based on an interest rate. Instead, the interest earned on these bonds is accrued and returned to the bondholder on bond maturity. As there are no periodic interest payments, the yield to maturity of zero coupon bonds is generally higher than traditional coupon bonds.
- The interest rates of zero coupon bonds are imputed; that is, it is an estimated interest based on the bond’s yield. This imputed interest is compounded till the bond maturity date, and the resultant amount represents the difference between the price of the zero coupon bond and its face value.
- The imputed interest rate and the maturity period are used to determine the discounted price of the bond. When the bond matures, the bondholder receives the entire face value of the zero coupon bond.
- Zero coupon bonds pose zero reinvestment risk and are immune to market ups & downs as there are no coupon payments. The interest rate is imputed and returns to the bondholder during maturity. The long-time horizons of zero coupon bonds are ideal for risk-averse long-term investors who wish to receive a lump sum as a fixed return in the future.
Suitable Tenure for Zero Bond Coupons
Zero coupon bonds are instruments for long-term investments. Moreover, the longer the maturity period, the lower the bond’s price. The ideal tenure for zero coupon bonds is 10 to 15 years. However, there are also zero coupon bonds of shorter tenures of less than one year.
Why Invest in Zero-Coupon Bonds?
A zero coupon bond is the perfect investment vehicle if you want a risk-free fixed income of a substantially significant value. The numerous prominent advantages of zero coupon bonds are reasons to invest in them. Their immunity to market fluctuations, assurance of lump sum fixed income in the future, and zero reinvestment risk are best for long-term investors with low risk-tolerance.
Zero coupon bonds are best for investors looking for long-term investments. These bonds deliver a lump sum when they mature and are thus best if you need a large amount of money for some major expense or investment in the future.
A zero coupon bond is also great for risk-averse investors who do not want to worry about fluctuations in the secondary market. These bonds are not subject to short-term or transient market risk as they do not offer any coupon payments.
Diversifying your investment portfolio is another reason to invest in zero coupon bonds.
Here is how zero coupon bonds work:
Suppose you buy a zero-coupon bond with a face or par value of Rs. 30,000. Say it has a maturity period of 20 years and comprises an imputed interest rate of 10%. So, as per the formula for calculating the bond price, the zero coupon bond might sell for Rs. 4459.
When the bond matures 20 years later, the bondholder will get the full face value of the bond as a lump sum amount of Rs. 30,000 — a whopping return of Rs. 25,541 on their investment. This profit arises from the interest rate associated with the bond that gets compounded annually until maturity.