Zero Coupon Bonds

Zero Coupon Bonds are a distinct category of debt instruments that do not pay periodic interest, or coupons, during their tenure. Instead, they are issued at a deep discount to their face (par) value and redeemed at full value upon maturity. The difference between the purchase price and the redemption value represents the investor’s return or implied interest. These bonds are also referred to as discount bonds or pure discount bonds and are widely used in both government and corporate finance.

Concept and Definition

A zero coupon bond is essentially a long-term debt security that pays no interim interest. Instead of periodic interest payments, the investor receives a single lump-sum amount at maturity. For example, a bond with a face value of ₹1,000 might be issued at ₹600; the investor earns ₹400 as interest income when it matures.
The yield on such a bond is determined by the difference between its purchase price and face value, adjusted for the time to maturity. Because of the lack of regular interest payments, the bond’s value increases gradually as it approaches maturity, a process known as accretion.
Mathematically, the price (P) of a zero coupon bond can be expressed as:
P=F(1+r)nP = \frac{F}{(1 + r)^n}P=(1+r)nF​
Where:

• F = Face value (redemption value)
• r = Discount rate or yield per period
• n = Number of periods to maturity

Features of Zero Coupon Bonds

Key characteristics of zero coupon bonds include:

• No Coupon Payments: Investors do not receive interest periodically; all income is realised at maturity.
• Issued at Discount: Bonds are sold significantly below their face value.
• Fixed Maturity Value: The maturity value is predetermined and equal to the bond’s face value.
• Price Volatility: The absence of coupons makes zero coupon bonds highly sensitive to changes in interest rates.
• Long-Term Investment: These are typically issued for longer tenures, such as 10, 15, or even 30 years.
• Tax Implications: Although no cash interest is received annually, investors may still be liable to pay tax on imputed interest, depending on local tax laws.

Types of Zero Coupon Bonds

Zero coupon bonds can be classified based on their issuer and structure:

1. Government Zero Coupon Bonds:
   • Issued by sovereign governments to raise funds.
   • In India, examples include Zero Coupon Government Securities (G-Secs) occasionally issued by the Reserve Bank of India (RBI).
   • Considered low-risk due to government backing.
2. Corporate Zero Coupon Bonds:
   • Issued by companies to raise long-term capital.
   • Carry higher risk compared to government bonds, reflecting the creditworthiness of the issuer.
3. Municipal Zero Coupon Bonds:
   • Issued by local authorities or municipalities to finance public projects.
   • May offer tax-free returns, depending on jurisdiction.
4. Stripped Bonds (Treasury STRIPS):
   • Created by “stripping” a standard coupon-bearing bond into separate components: one representing each coupon payment and one representing the principal repayment.
   • Each component can be traded individually as a zero coupon bond.

Advantages

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

• Predictable Returns: The maturity value is fixed, ensuring certainty of income at redemption.
• Suitable for Long-Term Goals: Ideal for investors planning for future needs such as retirement or education, as the payout aligns with a specific future date.
• No Reinvestment Risk: Since there are no periodic coupon payments, investors are not exposed to the risk of reinvesting interest at lower rates.
• Lower Initial Investment: The discounted issue price makes them accessible even with modest capital.

Disadvantages

However, zero coupon bonds also have certain limitations:

• High Interest Rate Sensitivity: Their prices fluctuate sharply with changes in market interest rates due to the long duration and absence of coupons.
• Lack of Regular Income: Unsuitable for investors seeking periodic returns, such as retirees.
• Taxation of Imputed Interest: In some tax regimes, investors may need to pay annual taxes on accrued interest even without actual cash receipts.
• Liquidity Risk: Some zero coupon bonds, especially corporate ones, may have limited secondary market liquidity.

Valuation and Yield

The yield or Yield to Maturity (YTM) of a zero coupon bond represents the annualised return if held until maturity. It is calculated using the formula:
YTM=(FP)1n−1YTM = \left( \frac{F}{P} \right)^{\frac{1}{n}} – 1YTM=(PF​)n1​−1
Where F, P, and n have the same meanings as above.For instance, if a bond with a face value of ₹1,000 is sold for ₹620 and matures in 5 years,
YTM=(1000620)15−1=0.104 or 10.4%YTM = \left( \frac{1000}{620} \right)^{\frac{1}{5}} – 1 = 0.104 \text{ or } 10.4\%YTM=(6201000​)51​−1=0.104 or 10.4%
This means the investor effectively earns an annual return of 10.4% over five years.

Market and Applications

Zero coupon bonds are commonly used in:

• Portfolio Diversification: They add balance to portfolios by providing fixed, predictable long-term returns.
• Institutional Investment: Pension funds and insurance companies use them to match long-term liabilities.
• Government Financing: Governments issue them to manage public debt efficiently.
• Speculative Trading: Traders may use them to speculate on long-term interest rate movements due to their high duration sensitivity.

Zero Coupon Bonds in India

In India, zero coupon bonds are issued under guidelines set by the Securities and Exchange Board of India (SEBI). Prominent issuers include the Industrial Development Bank of India (IDBI) and certain public sector undertakings. The RBI has also permitted the creation of zero coupon government securities through the stripping of interest-bearing bonds.
Zero coupon instruments are often used by financial institutions to structure deep-discount bonds or capital appreciation bonds, designed to attract long-term investors.

Economic and Financial Significance

Zero coupon bonds play a vital role in modern financial markets by providing:

• A clear measure of long-term interest rate expectations,
• Instruments for duration matching and liability management,
• Safe, long-term options for conservative investors, and
• A foundation for complex derivatives and structured finance products.