What Is A Zero Coupon Bond?
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond “matures” or comes due. So that’s how you profit: the difference between that initial discounted price, and what you collect when the bond comes due.
The biggest benefit of zero-coupon bonds is their reliability. If you keep the bond to maturity, you will essentially be guaranteed a sizable return on your investment. However, the maturity dates on zero coupon bonds are usually long-term—many don’t mature for ten, fifteen, or more years.
Thus, these are ideal for people who would require funds at a specific period of time in the future like children’s education or retirement or a planned tour.
Also, if you are not interested in watching the market trends and like the comfort of the ‘invest and forget’ strategy, then you can consider zero coupon bonds. If your investment portfolio primarily consists of growth investments and you are looking to add diversity to it, then zero coupon bonds can help you secure a guaranteed return for a fixed time period.
For example, a zero-coupon bond with a face value of Rs.20,000 that matures in 20 years with an interest rate of 5.5% might sell for around Rs.7,000. At maturity, two decades later, the investor will receive a lump-sum payment of Rs.20,000 — a Rs.13,000 return on investment. Here, the profit comes from interest that compounds automatically until the bond matures.
Zero coupon bonds are subject to interest rates risk if sold prior to the date of maturity. The value of this bond is inversely related to the rise in the interest rates; with rising in interest rates there is a decline in the value of these bonds in the secondary market. The sensitivity of long-term zero-coupon bonds to interest rates exposes them to duration risk.
This means that higher a bond’s duration, the greater will be its sensitivity to interest rate changes. Note: Duration risk is the risk that is associated with the sensitivity of a bond’s price to one percent change in the rate of interest.
Advantages Of Zero Coupon Bond
They often have higher interest rates than other bonds- Since zero-coupon bonds do not provide regular interest payments, their issuers must find a way to make them more attractive to investors. As a result, these bonds often come with higher yields than traditional bonds.
They offer a predictable payout- The other big advantage of zero-coupon bonds is their predictability. If these bonds are held to maturity, you’re guaranteed a return of the full face value. Plus, you’ll have gotten a deal: paying less now for more later.