What is a zero coupon bond? How does it work?

A zero coupon bond is a debt instrument that does not pay interest to the buyer. Instead, it comes at a discount and provides profit at maturity. Additionally, it is redeemable at face value. It falls under the fixed-income securities segment.

This bond provides higher returns than regular bonds because of the yield curve. Further, the interest income you earn from zero bonds is free from taxation.

If you’re wondering why to invest in a coupon bond, it is because various bonds provide regular interest payments to investors. So we will understand zero bonds in detail in this article. Read on.

Advantages of the zero coupon bond

You need to understand the advantages before investing in a zero coupon bond. They are as below:

Fixed Return

It is the right choice for an investor who prefers long-term investment or want to earn a lump sum amount. Further, it assures a fixed return to investors till the maturity period.

No reinvestment risks

It does not have reinvestment risk as the bond does not pay interest regularly. Moreover, investors do not receive any cash flow. And they have to reinvest regularly.

The rate they receive per year on a zero coupon bond is the same rate their money goes for in the reinvestment. It is the reason that investing in zero coupon bonds is beneficial to investors. This bond is a popular investment option when the market yield is high.

Trade-in secondary market

The investor can buy and sell these bonds in the secondary bond market. And they can do so before the maturity period at prevailing market rates.

Low investment

It is a discounted financial instrument. The value of the investment is small, which is affordable for investors who need to invest less money.

Limited risk

There is a limited risk when a person invests money in these bonds.

Predictable returns

The returns that investors receive on zero coupon bonds depend on their types. Some of the types are maturity, face value, and discounted face value. Investors can predict the returns of their investment in these bonds.

Disadvantages of zero coupon bond

Risk of Interest rate

If the investors sell the bond before its maturity date, they may face the risk of a lower interest rate. It is because the bond value is proportionate to interest rates. It means that when the market value of a coupon falls, the rate rises. Further, the issuers can redeem the bond before maturity when the rates fall.

Liquidity

The bond can get liquidity. As a result, investors have to compromise on a fair price when they need funds in an emergency.

The risk depends on the time duration

If you buy a long-duration bond, the chances that the rate of interest will change may be high. While for a short duration, there are fewer chances of change.

Income is taxable

Bonds issued by REC and NABARD are taxable. Additionally, it is treated as a capital gain income. Thus the income you earn from coupon bonds is taxable during its maturity.

Income is not regular

You will not get a regular income of interest when you invest in the bond market. Instead, you will get the return as a lump sum on the maturity date.

Trust issue

The maturity period of a bond is 10, 15, or more years. It is a long-term investment that builds trust issues in the mind of investors for their investment.

What is the investment time horizon for bonds?

A zero coupon bond is a long-term debt instrument. Hence it is suitable for investors planning their retirement and other long-term goals.

Further, they have a lower price than those available for trade on the stock exchange.

Who should invest in a zero coupon bond?

• A zero coupon bond is suitable for those who can wait a long time to redeem the bond. If they wait for the maturity time, they get more benefits. They are ideal for investors planning for education, marriage, and retirement funds.
• A zero coupon bond is suitable for those who can not follow market trends. Those who like to invest and forget can also invest in this bond.
• Investors looking to add diversity to their portfolio can opt for this type of bond. It is also suitable for a guaranteed return at the end of the term.
• It is the right fit for those who want to invest their money in a long-term investment plan.

Is a zero coupon bond different from a regular bond?

• You purchase zero bonds at a deep discount rate from the bond’s face value. As a result, you earn a good amount as returns.
• They have a higher return than regular bonds with the same maturity period because of the yield curve.
• In other bonds, the obligator has to pay interest to the bondholders. While in a zero coupon bond, they do not need to pay interest.

Is investing in coupon bonds safe in India?

It is a safe source of investment for fixed income and gets a good return on maturity.

What amount should you invest in zero bond market securities?

When you want to invest in zero bond securities, decide based on risk, reward capacity, and other crucial factors.

Conclusion

Investing money in a zero coupon bond is ideal for those planning long-term investments. It is also suitable for people who want to get a fixed return for a purpose. Retirement, children’s education, and marriage are some examples.

Furthermore, the investment amount is low. Additionally, you do not receive interest payments on a coupon bond. Investors need to pay taxes after the bond matures. It is capital gain taxable income.

It’s not suitable for an investor who wants to earn money for a short duration due to the longer maturity terms.

We hope this article answers your questions about the zero coupon bond. To know more about investment schemes, visit the Piramal Finance website. We can help you with better knowledge of financial products and services, especially credit cards and personal loan.