Zero coupon bonds are a special type of bond that works differently from traditional bonds. Instead of paying regular interest, they are sold at a lower price and then redeemed at their full value when they mature. This means you make a profit based on the difference between the purchase price and the face value. In this article, we’ll explain what zero coupon bonds are, who can issue them, how they work, who should invest in them, and their pros and cons. By the end, you’ll have a clear understanding of zero coupon bonds and whether they might be a good fit for your investments.
What Zero Coupon Bond Means?
Bonds are financial instruments issued by companies, governments, or financial institutions to obtain funds for various purposes. Among the various types of bonds, there is a special category known as zero coupon bonds.
In the context of bonds, “coupon” refers to the interest payment made to bondholders. As the name implies, Zero Coupon bond means there will be zero interest paid to the bondholders during the entire tenure of these bonds. These bonds are issued at a discount, and investors profit from the difference between the purchase price and the bond’s face value when it matures.
Investors do not receive any returns from zero-coupon bonds until maturity; they only earn their returns when the bonds mature and are redeemed at their full face value.
Example: A company, XYZ Ltd., issues a zero coupon bond with a face value of INR 2,000, maturing in 10 years. The bond is sold to investors for INR 1,200.
The difference between the issue price and the face value is INR 2,000 – INR 1,200 = INR 800. This INR 800 represents the profit for investors. During the 10 years leading up to maturity, investors do not receive any returns. Instead, they make their profit when the bond is redeemed for its full face value.
Who can Issue Zero Coupon Bonds in India?
In India, zero-coupon bonds can be issued by several types of entities, including:
- Government of India.
- Government-Owned Companies.
- Public Companies.
- Banks and NBFCs.
How Zero Coupon Bonds are Issued?
Here’s a simplified explanation of the process of how zero-coupon bonds are issued:
- Issuance decision: An issuer, such as a government, corporation, or financial institution, decides to issue zero coupon bonds as a way to raise capital.
- Determination of Terms: The issuer determines the terms of the bonds, including the face value, issue price, and maturity date. The issue price of a zero-coupon bond can be calculated either on an annual or semi-annual basis.
The formula for annually: Face value / (1+r)*n.
Where r represents the annual interest rate and n denotes the number of years until maturity.
The formula for semi-annually: Face value / (1+r/2) n*2
Where r represents the annual interest rate and n denotes the number of years until maturity.
- Approval and Registration: The issuer submits a draft prospectus to the Securities and Exchange Board of India (SEBI) for approval. SEBI evaluates the prospectus to verify that it meets all regulatory standards. After receiving approval, the issuer files the prospectus with SEBI for official registration.
- Offering to Investors: After registration, the bonds can be offered to investors. If the bonds are publicly traded, they must also be listed on a recognized stock exchange.
- Issuance and Sale: Investors who buy zero-coupon bonds receive investment certificates or bonds that confirm their purchase and investment amount.
- Redemption: At maturity, the issuer redeems the bonds at their full face value. The difference between the purchase price and the face value represents the profit for investors.
Who Should Consider Investing in Zero Coupon Bonds?
Investors who should consider investing in zero-coupon bonds include:
- Long-Term Investors: Zero coupon bonds are an attractive option for investors seeking long-term investments. These bonds are typically issued for extended periods and offer a fixed return at maturity without periodic interest payments. For individuals who want a predictable return and do not need regular income, zero-coupon bonds can be a suitable investment option.
- Low-Risk Tolerant Investors: Zero-coupon bonds, particularly those issued by reputable entities such as governments or high-quality corporations, provide a guaranteed return if held to maturity. Therefore, individuals seeking low-risk investments with predictable returns should consider these zero-coupon bonds.
- Investors Looking for Diversification: Investors seeking to diversify their portfolios might consider zero coupon bonds, as these bonds are not directly affected by fluctuations in interest rates or market conditions, making them a solid option for diversifying investment portfolios.
- Individuals Planning for Future Expenses: Investors saving for specific future goals, such as education, retirement, or marriage, may find zero coupon bonds appealing. These bonds offer a predictable amount of money at a future date, making them well-suited for aligning with long-term financial goals.
How to Invest in Zero Coupon Bonds?
Investing in zero coupon bonds in India can be done either offline or online. For offline investments, you need to visit banks, financial advisors, or brokers directly. Online investing is typically more convenient. Here are the steps to invest in zero-coupon bonds online effectively:
- Choose a Platform: For investing in zero-coupon bonds, select a trusted and reliable online platform that offers these investments. Some platforms where you can invest in zero-coupon bonds include RBI Retail Direct, Zerodha, Upstox, ICICI Direct, and HDFC Securities.
- Create an account: Open a demat and trading account with the chosen platform, which typically involves providing personal details and documents such as an Aadhaar card, PAN card, and others, and completing the KYC (Know Your Customer) process.
- Investment Research and Analysis: First, research the available zero-coupon bonds on the online investment platform. Next, analyze them based on key metrics such as issue price, face value, issuer credit rating, financial stability, maturity date, tax implications, etc. Finally, select the most appealing option that aligns with your investment goals and preferences.
- Deposit Funds: Transfer the required amount of money into your trading account to facilitate the purchase of bonds. This process includes connecting your bank account to your trading account and then initiating a transfer of funds. Ensure that you deposit sufficient funds to cover the cost of the bonds you intend to buy, including any associated fees or charges.
- Purchase Bonds: Next, place an order to buy the selected zero-coupon bond. Once the transaction is completed, your bond units will be reflected in the “Portfolio Overview” or “Bond Holdings” section, depending on the platform’s interface.
Advantages & Limitations
Advantages
- Fixed Returns: Zero-coupon bonds offer a guaranteed return if held until maturity, as they are initially sold at a discount and redeemed at their full face value.
- Unaffected by Market conditions: Returns from zero coupon bonds are not influenced by market conditions or changes in interest rates. Investors will receive the full face value at maturity, regardless of the market situation at that time.
- Long-Term Investment: These bonds are often issued with long maturities, making them suitable for long-term financial planning and goals.
- Suitable for Saving Goals: They are ideal for saving towards specific future expenses, such as education, retirement, or a major purchase, due to their predictable maturity value.
Limitations
- No Regular Income: Unlike other bonds that provide regular interest payments until maturity, zero-coupon bonds do not offer any interest payments during their term. This can be a disadvantage for investors who prefer a consistent income stream.
- Lower Liquidity: These bonds may be less liquid than other types of bonds, making it harder to sell them quickly at a desired price.
- Potential for Lower Total Returns: Although zero-coupon bonds can provide attractive returns if held to maturity, their extended holding period and the impact of taxes can sometimes lead to lower overall returns compared to bonds that offer periodic interest payments.
- Issuer Credit Risk: Zero coupon bonds are subject to the credit risk of the issuer. If the issuing entity experiences financial difficulties or defaults, investors may not receive the full face value at maturity, resulting in a loss of principal.
Taxation on Zero Coupon Bonds
Investing in zero-coupon bonds may have income tax implications if the investor makes a profit. Here are the cases to consider:
- Zero coupon bonds: purchased from the primary market and sold at maturity
Zero-coupon bonds can be classified into two categories: notified and non-notified. Notified zero-coupon bonds are officially recognized by the government or regulatory authorities. These bonds are issued for the long term. If you purchase these bonds when they are first issued in the primary market and hold them until maturity, any profit made upon redemption is taxed as long-term capital gains (LTCG) at 10% without indexation. Additionally, you can claim an exemption of up to INR 1.25 lakh on these gains. Conversely, non-notified zero-coupon bonds, which are not officially recognized or listed, are taxed as interest income according to your individual income tax slab.
- Zero coupon bonds: purchased from the secondary market and sold at maturity
For notified zero-coupon bonds bought from the secondary market and redeemed at maturity, if the holding period is less than 12 months, the gain is taxed as short-term capital gains (STCG) and added to your normal income, taxed according to your individual tax slab. If held for more than 12 months, the gain is taxed as long-term capital gains (LTCG) at 10% without indexation. For non-notified zero-coupon bonds, any gain is treated as interest income and taxed based on your individual income tax slab.
- Zero-coupon bonds: purchased from the secondary market and sold in the secondary market.
Zero-coupon bonds purchased and sold on the secondary market are taxed differently based on whether they are notified or non-notified. For notified zero-coupon bonds, if you buy them in the secondary market and sell them within 12 months, any profit made is taxed as short-term capital gains (STCG). This profit is added to your normal income and taxed according to your individual income tax slab. However, if you hold the bond for more than 12 months before selling, the profit is taxed as long-term capital gains (LTCG) at a rate of 10% without indexation. On the other hand, gains from non-notified zero-coupon bonds purchased and sold in the secondary market are treated as interest income and taxed according to your individual income tax slab.
- Zero coupon bonds sold at a loss
If you sell zero coupon bonds at a loss, the tax treatment depends on whether the bonds are notified or non-notified. For notified bonds, if you hold them for less than 12 months before selling, the loss is considered a short-term capital loss. If held for more than 12 months, it’s a long-term capital loss. These losses can be used to offset any capital gains you have in the same year or carried forward for up to 8 years to reduce future capital gains. For non-notified bonds, the loss cannot be used to offset other income, so there’s no direct tax benefit from the loss.
Conclusion
Zero coupon bonds are a distinctive type of bond that differs from traditional bonds by not offering periodic interest payments. Instead, these bonds are sold at a discount and redeemed at face value upon maturity, guaranteeing a return if held to maturity. This feature makes them particularly suitable for long-term financial planning. Zero coupon bonds can be issued by governments, public sector undertakings (PSUs), private and public corporations, and financial institutions. Investors can choose to invest in these bonds through either online or offline channels. While zero coupon bonds offer several benefits, including predictable returns and simplicity, they also have limitations. By carefully considering these factors and how they align with your financial objectives, you can determine whether zero-coupon bonds are a suitable investment for you.
FAQs
Q1. Is there any risk in investing in zero-coupon bonds?
A1. Yes, investing in zero-coupon bonds carries several risks. These include sensitivity to interest rate changes, which can lead to significant price fluctuations, and credit risk if the issuer defaults. There is also inflation risk, which can erode the real value of the return, and liquidity risk, as these bonds can be harder to sell quickly if needed. So, it’s important to do proper research and analysis before making any decision.
Q2. What does zero coupon bond mean?
A2. A zero coupon bond is a type of bond that does not provide periodic interest payments. Instead, it is issued at a discount to its face value and is redeemed for its full face value at maturity. The difference between the discounted price and the face value is the return for investors.
Q3. Can I exit zero coupon bonds before maturity?
A3. Yes, you can exit zero coupon bonds before maturity by selling them on the secondary market. However, the price may vary based on market conditions and interest rates, potentially resulting in a gain or loss.
Q4. What happens if a company issuing a zero coupon bond commits fraud and fails to return the investor’s money at maturity?
A4. If a company issuing a zero coupon bond commits fraud and fails to return the investor’s money at maturity, the investor may face a total loss of their principal, and legal action may be necessary to seek recovery.
Q5. Is it better to invest in zero-coupon bonds through online or offline methods?
A5. Investing in zero-coupon bonds through an online medium is generally better due to its convenience and efficiency. Online platforms offer easy access to a wide range of bonds, real-time information, and streamlined transactions.
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