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Zero Coupon Bonds – Taxation, Advantages & Disadvantages

  • Akshatha Sajumon
  • 18 Jan
  • 8 minutes

Zero coupon bonds fall under the fixed-income securities segment. These don’t pay any interest or coupon, and at the time of maturity, the investor receives the face value or par value. Zero coupon bonds are also referred to as ‘Zeroes’ by many traders for this reason. These bonds generally have 10-15 years to maturity. Hence, they are traded at a deep discount. The bond prices vary as per the time to maturity.  

So, why will any investor invest in a zero-coupon bond? The primary reason for investing in these is that they are issued and trade at a discount from the face value. 

Here, we will explain zero-coupon bonds in detail and some of the factors that investors must consider while investing in these instruments.

What are Zero Coupon bonds?

To understand a zero-coupon bond, investors must first understand the meaning of a Bond. A bond is a fixed-income financial instrument for long-term investing. Through a bond, two parties, i.e.the investor and the issuer, mutually agree to certain terms. This mainly includes that the investor lends money to the bond issuer and the bond issuer, in return, pays some interest to the investor at the time of bond maturity. The price at which a bond is issued is called its Face value.

A zero coupon bond is also known as a discount bond since it is issued at a discount to the face value. In simple words, these bonds are traded at a deep discount.

How does an investor earn from Zero Coupon bonds?

At the time of maturity, the bond issuer will pay the face value of the bond to the bondholder. Thus, an investor will earn from the difference between the purchase price of the bond and its face value at maturity. There is no interest income or coupon to be earned from these bonds. 

Investment time horizon for Zero Coupon Bonds

Zero-coupon bonds are long-term debt instruments. These are ideal for investors who are planning their retirement. The longer the time until maturity, the lower the price of a zero-coupon bond. These bonds are traded on the stock exchange, and investors can choose to sell them before maturity.

Prices fluctuations of Zero-Coupon Bond

Since an investor gets the face value of a zero-coupon upon maturity, the prices of these bonds can fluctuate far more than a coupon or interest-earning bonds.

What is the tax treatment for Zero Coupon Bonds?

Zero coupon bonds that are notified and issued by REC and NABARD are taxable. Earnings from zero coupon bonds are also subject to capital gains tax at the time of maturity. The earnings or capital appreciation for zero coupon bonds is the difference between the maturity value and purchase price of the bond.

Who should invest in Zero Coupon Bonds?

Investors must note the most important feature of these bonds before investing that they do not have any interest or coupon. The points mentioned below will help provide clarity on the types of investors who can choose to invest in zero coupon bonds:

  • These are best suited for investors who can wait for funds to be redeemed at a specific period in the future. For example, those who want to make funds available for children’s higher education or are planning for retirement. 
  • Investors who do not always follow the market trends and are comfortable with the ‘invest and forget’ idea can opt for zero coupon bonds. 
  • Investors who are looking to add diversity to their portfolio that mainly comprises growth investments can invest in zero coupon bonds. This is because zero coupon bonds can help in securing a guaranteed return at the end of a fixed time period. 
  • Since these bonds offer discounts for longer investment tenures, they are ideal for those who have long-term investment plans. 

What are the benefits of investing in Zero-Coupon Bond?

A zero-coupon bond is a preferred investment option since it is secured, especially if invested for the long term. Some of the benefits that these offers are:

  • Predictable Returns: Since returns on zero-coupon bonds are the difference between maturity/face value and discounted face value, investors can predict returns on a zero-coupon bond. 
  • Low Investment: Since these are deeply discounted financial instruments, their value at the time of investment is often small and easily affordable for investors.
  • Limited Risk: Investors who make investment in a zero-coupon bond through verified and reputed issuers can limit their total risk in this investment.
  • Ideal for Long Term Financial Goals: A zero-coupon bond is best suited for investors who are looking to fulfill their long-term (beyond ten years) goals such as child’s education, post-retirement goals, etc.
  • Traded in Secondary Market: These bonds can be easily bought and sold before maturity at prevailing market rates in the secondary market.

What are the drawbacks of investing in Zero-Coupon Bond?

A zero-coupon bond has certain shortcomings, too. Investors must be well aware of these before making an investment choice:

  • Trust factor of Issuer: Since zero-coupon bonds have lengthy maturity periods, it can be challenging for investors to continue their trust in the issuer till the maturity date arrives.
  • Interest Rate Risk: Zero-coupon bonds that are sold before maturity are subject to interest rates risk. This is because the value of these bonds is inversely proportional to interest rates. Hence, if interest rates rise, the value of these bonds declines in the secondary market. Additionally, issuers have the option of redeeming the bond before maturity in case the interest rate of the bond falls. This is often done at a pre-determined lower price, as mentioned at the time of bond issuance. 
  • Liquidity: While liquidating these bonds in the secondary market, there are chances that an investor may have to compromise on the fair price, especially in case of an emergency.
  • Duration Risk: Duration risk correlates the sensitivity of a bond’s price to a percentage change in interest rates. Long-term zero-coupon bonds are sensitive to interest rates and are therefore exposed to duration risk. In simple terms, the higher a bond’s duration, the more sensitive it will be to interest rate changes. The duration and the value of Zero Coupon bonds are inversely related. The longer the duration or time until the maturity date, the lesser the investors have to pay for it. Therefore, these are generally issued with a time horizon of 10 to 15 years. 
  • Tax on Income: Income tax is applicable on the returns generated at maturity from zero-coupon bonds.
  • No Regular Income: Since these do not involve regular interest payments, returns can be generated only in lump sum at maturity.

Conclusion

The main distinguishing factor between zero-coupon bonds and other bonds is that investors do not receive periodic interest payments. Instead, the investment generates a lump-sum payment at the time of bond maturity. Thus, zero coupon bonds are the best fit for investors who have a future financial goal and are ready to wait for a longer term to redeem the investment.

FAQs on Zero-coupon bonds

  1. Why would you invest in a zero-coupon bond?
    Zero coupon bonds come with several benefits. The biggest is the predictability of returns. If an investor does not sell the bond prior to maturity, he/she does not have to worry about market fluctuations since the future value of the investment is known.
  1. How do you make money with a zero-coupon bond?
    The earnings from a zero-coupon bond are primarily the difference between the purchase price of the bond and the maturity value or face value.
  1. What is the duration of a zero-coupon bond?
    Duration in a zero-coupon bond is the time to maturity. Normally, these bonds come with a duration of 10 years or more.
  1. How to invest in zero coupon bonds?
    Zero coupon bonds are issued periodically by governments and pseudo-government institutions. Once these bonds are issued, they can be bought through stock exchanges such as NSE and BSE. Investors will need to open a Demat account for investing in zero coupon bonds through stock exchanges. 
  1. What is the difference between a coupon bond and zero-coupon bond?
    Coupon bonds pay interest or coupon in predetermined intervals throughout the bond’s duration or time to maturity. Zero coupon bonds do not pay any coupon or interest throughout the duration of the bond. Instead, these are sold at a discount to face value and redeemed at face value upon reaching maturity.

 

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Akshatha Sajumon