Zero Coupon Bond

A Zero-Coupon Bond (ZCB), also known as a discount bond or deep-discount bond, is a type of debt instrument that does not pay periodic interest or coupon payments during its tenure. Instead, it is issued at a price significantly lower than its face (par) value and redeemed at full face value upon maturity. The investor’s return comes from the difference between the purchase price and the redemption value, representing the implied interest earned over the life of the bond.
Zero-coupon bonds are popular among investors seeking predictable, long-term returns, as they provide a fixed lump sum on maturity without interim cash flows.

Characteristics and Structure

The defining feature of a zero-coupon bond is the absence of periodic coupon payments. Unlike regular bonds that pay semi-annual or annual interest, ZCBs accumulate interest internally, which is realised only at maturity.
Key characteristics include:

• Issued at a Discount: Sold at a price below par value. For instance, a bond with a face value of ₹1,000 may be issued for ₹700.
• No Periodic Interest Payments: The investor receives no interest before maturity.
• Fixed Maturity Value: The bondholder receives the face value (e.g., ₹1,000) at maturity.
• Long-Term Instrument: Typically issued with maturities ranging from 1 to 30 years.
• Price Fluctuation: Highly sensitive to interest rate changes due to long duration.

The implicit yield, also called the yield to maturity (YTM), is determined by the rate at which the discounted purchase price grows to the face value over time.

Valuation and Yield Calculation

The value of a zero-coupon bond is the present value of its face value, discounted at the prevailing market interest rate. The relationship can be expressed as:
P=F(1+r)nP = \frac{F}{(1 + r)^n}P=(1+r)nF​
where:

• PPP = Present price of the bond
• FFF = Face (maturity) value
• rrr = Market interest rate (or yield)
• nnn = Time to maturity in years

For example, if a zero-coupon bond with a face value of ₹1,000 matures in 5 years and the yield is 8% per annum, the present price would be:
P=1000(1+0.08)5=₹680.58P = \frac{1000}{(1 + 0.08)^5} = ₹680.58P=(1+0.08)51000​=₹680.58
Hence, the investor earns ₹319.42 as the total return at maturity, equivalent to the interest accumulated over 5 years.

Issuance and Market Types

Zero-coupon bonds may be issued directly by governments, financial institutions, or corporations, or created from existing coupon bonds through a process known as stripping.

• Government-issued ZCBs: These include Treasury Bills (short-term) and long-term bonds issued at a discount, considered risk-free.
• Corporate ZCBs: Issued by companies to raise capital, usually offering higher yields to compensate for credit risk.
• STRIPS (Separate Trading of Registered Interest and Principal of Securities): In this method, the interest and principal components of a regular bond are separated and traded individually as zero-coupon instruments.

In India, the Reserve Bank of India (RBI) and various public sector undertakings have issued zero-coupon bonds, while institutions like IDBI, ICICI, and NABARD have used them to mobilise long-term funds.

Advantages of Zero-Coupon Bonds

Zero-coupon bonds offer several benefits to investors and issuers alike:

• Predictable Returns: The investor knows exactly how much will be received at maturity.
• No Reinvestment Risk: Since there are no periodic coupons, the investor avoids the risk of reinvesting interest payments at lower rates.
• Long-term Planning: Suitable for future financial goals such as education or retirement.
• Capital Appreciation: Offers significant appreciation over time due to compounding.
• Price Transparency: The return can be easily calculated based on purchase price and maturity value.

For issuers, zero-coupon bonds provide immediate capital without recurring interest obligations, making them useful for managing cash flows efficiently.

Disadvantages and Risks

Despite their benefits, zero-coupon bonds carry certain limitations and risks:

• Interest Rate Risk: Bond prices are highly sensitive to fluctuations in market interest rates. A rise in rates reduces bond prices significantly.
• No Periodic Income: Unsuitable for investors seeking regular income, such as retirees.
• Tax Implications: In many jurisdictions, the imputed interest (accrued annually) is taxable even though no cash is received until maturity.
• Credit Risk: Corporate zero-coupon bonds carry the risk of default by the issuer.
• Liquidity Risk: These bonds are often less liquid compared to coupon-paying securities.

Investors must consider these factors in line with their investment horizon, tax status, and risk tolerance.

Applications and Investment Use

Zero-coupon bonds are particularly attractive for long-term investors with fixed financial targets. Their applications include:

• Retirement and Education Planning: Ensures a lump-sum payment at a predetermined future date.
• Portfolio Diversification: Acts as a stable, low-correlation asset in a diversified portfolio.
• Institutional Investment: Pension funds and insurance companies use them for liability matching.
• Tax Planning: In certain cases, investors can structure portfolios to defer tax until maturity.