In earlier days, companies used to raise funds from the 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.
What is Zero Coupon Bond?
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.
How is the price of Zero Coupon Bond Calculated?
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:
- Face value = Future value or maturity value of the bond
- r = Required rate of return or interest rate
- n = Number of years until maturity
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.
Suitable Tenure for Zero Bond Coupon
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.
Who Should Consider Zero Coupon Bonds For Investing?
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 Zero Coupon bond. It will diversify the portfolio, as well as guarantee a lump sum at a fixed time.
Advantages of Zero Coupon Bond
It is important to understand the advantages of a Zero Coupon bond before opting for this investment. The advantages are mentioned below:
- No reinvestment risk: Other coupon bonds don’t allow investors to a bond’s cash flow at the same rate to the investment’s required rate of returns. But the Zero Coupon bonds remove the reinvestment risk. Zero Coupon bonds do not allow any periodic coupon payments and thus a fixed interest on Zero Coupon bonds is assured.
- Fixed returns: The Zero Coupon bond is an ideal choice for those who prefer the long-term investment and earn in lump sum. The reason behind this is the assurance of a fixed return, provided the investment has been kept till maturity.
- Long-time horizon: The long time horizon of the Zero Coupon bond is a significant advantage for long-term investors. A fixed amount can be availed via a long-term investment without worrying about any market turmoil.
Disadvantages of Zero Coupon Bond
Despite having many advantages, the Zero Coupon bond has a few disadvantages as well, which are mentioned below:
- No regular income: The Zero Coupon bond provides in a lump sum; therefore, it prevents a regular cash flow. This bond will not benefit investors with the requirement of regular cash.
- Interest Rate Risk: Interest rates of this bond can decline over time due to fluctuation in the market. Therefore, the investors will always have interest rate risk if sold before the maturity date.
- Illiquidity in the secondary market: The value of this bond shares a negative correlation with the rise of the interest rate. A rise in the interest rate indicates a decline in the fund value in the secondary market.
- Duration risk: Duration risk is related to the sensitivity of the bond’s price to a one percent change in the interest rate. The longer the duration, the more it becomes sensitive to change in interest change.
Importance of Zero Coupon Bond
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.