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In the earlier Era, the Bond documents played a vital role in the Government. They made a mark before the shares were available to the investors. The companies used to raise different funds with a written guarantee of the promise to pay it back later with interest. This guarantee is none other than the Bond. In India, the Bonds are broadly classified into two types: Government Bonds and Co-operate Bonds. In this article, we will be discussing the ‘Zero Coupon Bonds’ and what are its benefits and demerits and who should invest and what makes this investment unique and its formulation.
Usually, the Bonds are quite uninteresting and people don’t take much interest to talk about this. Most people will have only a partial understanding of how they work and what is the impact.
What are Zero Coupon Bonds
A Zero Coupon Bond is a debt security which is sold at a discount and the best part in it is that you do not have to pay any interest payments to the bondholder. In other words, it’s a bond that sells less than its face value and does not make any coupon payments or periodic interest payments during its life. At the time of maturity, this can be redeemed at its face value allowing the bondholder to make a profit.
It has been seen that in Companies, Schools and Government Workplaces, bonds are used as a way to the Finance Expansions and other long-term projects. Usually, the decision to issue a Bond starts with a proposal for new projects. When the authorized board or the Government Body approves the plan or any idea, then a Bond is issued. The process is not that easy. It might take few months to get the bond drafted and issued to the public. The interest rate and the terms of the bond are usually set when the bond is initially drafted up. And by the time, the draft is issued the interest rates change.
And this is the reason why the Bonds are usually issued either at a premium rate or at a discount. Since the stated interest rate of the bond cannot be changed that’s why the sales price of the bond is changed. A bond issued at a premium sells for more than a stated value. Like for an example, a Rupees 100 Bond can be sold for Rupees 500. Whereas, a discounted bond is different the price of the bond is set to lower value. Like for an example; A 100 Rupees Bond can be sold for 80 Rupees.
Why are Bonds Important
The Governments need to borrow money. They borrow money by selling the bonds in the private sectors. Usually, the investors are quite happy to buy Government Bonds. They are seen as the safe investment options and the investors get a guaranteed rate of interest in return.
Who Should Invest in a Zero Coupon Bond
The Zero Coupon Bonds are ideal for the people who require funds at a specific period of time especially, in the future such as children’s education or retirement or a planned tour. If in case you are not interested in watching the market trends and like the comfort of the “Invest and Forget” strategy then Zero Coupon Bond is the best option to choose.
If your growth investments graph is quite high and you want to add a little diversity to it, then zero coupon bonds will help you secure a guaranteed return for a fixed period of time. These bonds offer great discounts for long tenures of investment and are perfect for the long-term investment plans.
Formulation: Mathematical Representation of the Zero Coupon Bond:
The price of the Zero Coupon Bond can be calculated by using the following formula:
P=M/ (1+r) ^n
M= Maturity Value
r= Investor’s required annual yield/ 2
n= Number of years until maturity *2
Like for an example; if you want to purchase a Company’s Zero Coupon Bond that has Rs 1000 Face Value which matures after 3 years and you will be earning an interest of 10% per year on the investment. Thus, according to the formula;
1000/ (1+ .05) ^6= Rs 746.22
The greater the length until the zero coupon bond’s maturity the less is the amount that the investor has to pay. So if the Company’s Rs 1000 Bond is matured in 20 years instead of 3 years then you have to pay;
1000/ (1+.05) ^40= Rs 142.05
Advantages/ Benefits of the Zero Coupon Bonds
- The Bonds offer good graceful returns on maturity while keeping the option of selling them on the secondary market open if the interest rates decline sharply.
- The investors do not have to pay any tax on the interest since the bonds are issued at a discounted price and later redeemed at a face value.
Disadvantages of the Zero Coupon Bonds
- The Consequence of Paying taxes over annual accrued (phantom) interests which are not received but after maturity creates a negative cash flow over the active lifetime of bonds.
- The Zero-Coupon Bond prices are highly volatile. When the market’s interest rate increase the zero-bond prices drop significantly, resulting in a great loss of capital when the investors sell the bond before the maturity period.
- For the Zero- Coupon Bondholders there is no benefit to raising the interest rates because there are no coupon interests to reinvest.
- Many zero coupon bonds have call provisions as they allow the investors to redeem the bonds before the maturity period before the interest rates are dropped.
How is Income from these Bonds treated
The inventors of the notified zero coupon bonds are issued by the NABARD and REC and are liable to pay only the capital gains tax on maturity. The capital appreciation is such cases is the difference between the Maturity Price and Purchase price of the Bond.
In case of the non-notified zero coupon bonds, the difference between the maturity and the purchase price is considered as Interest and is taxed accordingly.
Like the growth market, the fixed income security market must have a clear approach to the investment goals and horizon. The Zero Coupon Bonds can be a great option if used cautiously and in sync with your investment purpose.
Thus, the Zero Coupon Bonds are the long-term investments and they are sold without a stated rate of interest. This is why many companies and the Government Bodies do not have to worry about changing the interest rates. These bonds are sold at a discount and do not have to pay a standard monthly interest percentage like the normal bonds do. Instead, the investors receive a gain of an appreciated bond at maturity. Instead of paying regular interest payments, it provides you one lump sum amount at the time of maturity.