Zero coupon bond
Key Takeaways
Zero-coupon bond or ZCB is a financial instrument which does not pay any interest or coupon rate
Zero-Coupon Bonds can render great returns if used strategically for the investment goal
ZCBs prove to be a good option for long term investments
What is a Zero-Coupon Bond?
Zero-coupon bond or ZCB is a financial instrument that does not pay any interest or coupon rate but is, instead, issued at a deep discount and is redeemed at face value on maturity.
The return earned by the investor is the difference between the issue price and the redemption price.
Yield to maturity of Zero-Coupon Bonds
Zero-Coupon Bonds can render great returns if used strategically for your investment goal. In absence of any exceptional case, like intermittent coupon payments, Zero- Coupon Bond’s yield to maturity is calculated as:
Yield = (FV/PV)1/n – 1
Where, FV = Face value
PV = Present Value
n = number of periods
Example
Say, a one-year ZCB with par value of Rs 100 is issued at Rs 92, which means that the investor which earns Rs 8 on the investment or 8.87 percent.
In India, mostly T-bills are issued in the form of ZCB with maturities of 91, 182, 364 days.
Who should invest in a Zero-Coupon Bond?
It should be kept in mind that ZCB doesn’t render regular interest payments. Since most of the zero-coupon bonds generally offer deep discounts for a longer period of investment, ZCBs prove to be a good option for investors who would need funds at a particular period in future like weddings, children’s education, retirement etc. It is also a perfect option for people who do not want to regularly monitor market trends as it offers guaranteed return for a fixed period.
Risks associated with Zero-Coupon Bonds
As there is no coupon rate, ZCBs are safer as compared to other fixed-income instruments, which are sensitive to changes in interest rates. But ZCBs do possess risk subjected to changes in interest rates if sold before maturity. The value of ZCB and interest rate are inversely related, so an increase in interest rate decreases the value of the bond in the secondary market.
What are the advantages of a Zero-Coupon Bond?
Zero-Coupon Bonds prove to be a safer option as compared to other fixed income instruments. They render good returns at the time of maturity and if interest rates fall dramatically, there is an option to sell them in secondary markets.
