What are zero coupon bonds?
(We understand how zero coupon bonds work and if they are really worth it)
Most of us know what bonds are and how they work. A bond is basically an instrument where the issuing company receives the principal amount and in turn we receive interest payments along with the principal amount at redemption.
But what if the company does not pay us our interest?
Well so what’s the point of buying one, right?
There is something called zero coupon bonds.
I will be discussing how they work, what are the types of zero coupon bonds, how are they taxed, why do companies issue zero coupon bonds and how does one calculate the yield on it.
I hope this information would let you make an informed decision on whether you should invest in these bonds. You can ask your queries in the comment section and I would try to answer them in the best of my knowledge.
So lets begin
Lets assume you run a company and you are in dire need of funds. You cant go to your bank to ask for more funds since you have already exhausted your credit limits. You don’t want to issue regular bonds because your project has uneven cash flows. So what do you do now? You issue zero coupon bonds.
Well so how does the investor get his return if you aren’t transferring him regular interest payments?
You issue bonds at deep discount.
Lets assume the face value of these bonds are 100 rupees each. You issue these bonds at 100 rupees each but they are sold to investors at 80 rupees each for a maturity period of 10 years. With this you don’t need to bear the burden of paying regular interest to your bond holders. Usually companies which manufacture products that require extensive research issue these bonds to solve their liquidity crunch.
Now lets talk about the types of zero coupon bonds
Corporate bonds
Corporate zero coupon Bonds are those bonds which are issued by corporate entities.
Examples include Adani Properties Private limited bond which has its face value as 1,00,00,000.
Government zero coupon bonds
As the name suggest these are those bonds which are issued by the government.
For eg T-bills are zero coupon bonds.
So how does one calculate yield on these bonds?
Here is the formula to calculate yield for zero coupon bonds or any type of bonds. We assume the bond is held till maturity and excludes any taxes or transaction costs.
YTM = [(Face Value / Purchase Price) ^ (1 / Years to Maturity)] - 1
You can use this formula to calculate the yield to maturity of any zero coupon bonds.
Why do investors buy zero coupon bonds?
Discounted Purchase: Zero coupon bonds are typically sold at a discounted price compared to their face value. Investors can buy these bonds at a lower price, allowing them to potentially earn a higher return upon maturity.
Capital Appreciation: Since zero coupon bonds are purchased at a discount, investors have the potential for capital appreciation when the bond reaches its maturity date. They receive the full face value of the bond, which can result in a significant profit.
Long-term Investing: Zero coupon bonds often have longer maturity periods, which can make them suitable for investors with long-term investment goals. By holding these bonds until maturity, investors can plan for specific future financial needs or goals.
What are the risks associated with these bonds?
Interest Rate Risk: Zero coupon bonds are susceptible to changes in interest rates, as their return is tied to the difference between the purchase price and the face value of the bond. If interest rates rise, the value of the bond will decrease, and investors may incur a loss if they decide to sell the bond before maturity.
Inflation Risk: Zero coupon bonds may also be subject to inflation risk, which is the risk that inflation will reduce the purchasing power of the bond’s return. Since zero coupon bonds provide a fixed return, inflation can erode the real value of the return over time.
Liquidity Risk: While zero coupon bonds are highly liquid, their market liquidity can be affected by market conditions, such as changes in interest rates or credit risk. This can make it more difficult for investors to sell their bonds at a fair price. Government bonds usually have high liquidity than corporate bonds.
What is the taxation on zero coupon bonds?
Since these bonds don’t give out regular interest payments and their sole motive is capital appreciation , taxation on these bonds are subject to capital gains tax and nothing else.
Even T-bills issued by the RBI are subject to short term capital gains tax.
To summarize
Zero coupon bonds do not pay regular interest payments.
They are issued at a discount to their face value and pay the full face value at maturity.
Investors buy zero coupon bonds due to their discounted purchase price and potential for capital appreciation.
Types of zero coupon bonds include corporate zero coupon bonds and government zero coupon bonds (e.g., T-bills).
Yield on zero coupon bonds can be calculated using the yield to maturity formula.
Risks associated with zero coupon bonds include interest rate risk, inflation risk, and liquidity risk.
Taxation on zero coupon bonds is based on capital gains.
Zero coupon bonds provide a unique investment opportunity for long-term investors seeking capital appreciation.
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