In earlier days, companies used to raise funds from investors based on a written guarantee. This written guarantee is known as a bond. Coupon bonds provide coupons or interests at regular intervals. Zero-Coupon Bonds, as the name suggests, do not provide any coupon or interest during the tenure but repay the face value at the time of maturity.
Zero Coupon Bond, also known as the discount bond, is purchased at a discounted price and does not pay any coupons or periodic interests to the fundholders. Money invested in Zero Coupon Bond does not generate a regular interest during the tenure. The annual returns on the principal amount are included in the face value and paid to the investor at the time of maturity. Therefore, the investors get a lump sum at the end of the tenure.
There are two types of Zero Coupon Bonds, which are corporate Zero Coupon bonds and Government Zero Coupon bonds.
The Zero Coupon Fund valuation can be done either on an annual or semi-annual basis. The annually Zero Coupon Bond and the semi-annual Zero Coupon Bond can be measured using two simple formulas, which are mentioned below:
Price of Zero Coupon Bond calculated annually
|Face Value / (1 + r) n = price of bond|
Price of Zero Coupon Bond calculated semi-annually
|Face Value / (1 + r/2) n*2 = Price of bond|
In both the formulas:
Both the formulas are similar except for the r or the required rate of return being divided by two and the n or years until maturity being multiplied by two for measuring the price of bond semi-annually.
The time and the maturity value of Zero Coupon bonds share a negative correlation. The longer until the maturity date, the less the investors have to pay for it. Therefore, the Zero Coupon bonds generally come with a time horizon of 10 to 15 years. On the other hand, these bonds with a time period of less than one can be a short-term investment option.
Zero Coupon Bond is most suitable for people wishing for long-term investment and willing to earn the return in a lump sum. People who want to get the amount at a specific time or are investing for any future event such as a child’s education or business should opt for the Zero Coupon funds.
Investors who don’t want to keep investing without having to bother about any market trends or ups and downs are suitable for this fund. Moreover, investors looking for portfolio diversification, with a minimum risk rate can choose a Zero Coupon bond. It will diversify the portfolio, as well as guarantee a lump sum at a fixed time.
It is important to understand the advantages of a Zero Coupon bond before opting for this investment. The advantages are mentioned below:
Despite having many advantages, the Zero Coupon bond has a few disadvantages as well, which are mentioned below:
The absence of a regular income under the Zero Coupon Bond funds makes it unappealing to many investors. Contrarily, others find it suitable for meeting long-term investment objectives. It allows investors to earn risk-free interest over a long period of time.
Zero-Coupon Bonds can be highly beneficial if purchased when the interest rate is high. Purchasing municipal Zero-Coupon can be a great way to avoid tax since they are tax-free. However, this is applicable for investors living in the state where the bond has been issued.
Zero-Coupon bonds come with both pros and cons. However, the features can have a different effect on different investors. Investors with long-term investment goals find this bond suitable, but investors with short-term investment goals may think otherwise. Therefore, investors should decide to go or not go for Zero-Coupon Bonds as per their investment objective.