Zero Coupon Bonds

Zero Coupon Bonds in India

Bonds without coupon or interest payments are called zero coupon bonds. Simply put, these bonds don't have interim cash flows after you invest in them. You get your principal back with the profits (or losses) all at once on the maturity date.

Difference between zero coupon bonds and normal bonds

Instead of a normal bond where you pay the face value and earn regular interest payments, zero coupon bonds are sold at a discount to the face value.

The following table highlights all the major differences between zero coupon bonds and normal bonds.

Are zero coupon bonds a good investment?

Zero coupon bonds are excellent for investors who want to invest in Bonds but are not keen on receiving regular interest payments. Further, investing in zero coupon bonds eliminates the reinvestment risk which is the risk that you may have to invest interest payments you receive at lower interest rates if interest rates in the economy fall.

Who should not invest in zero coupon bonds?

Zero coupon bonds should be avoided by investors who are looking to generate a stable cash flow from interest payments.

NRI eligibility for zero coupon bonds

NRIs are eligible to invest in zero coupon bonds issued by governments and PSUs but not eligible for zero coupon bonds issued by private sector companies. Investing in government zero coupon bonds may have some restrictions for NRIs. Please do your due diligence before investing.

Taxability of zero coupon bonds in India

Taxation of zero coupon bonds depends on whether they are notified or non-notified.
All gains (difference between purchase price and face value) from non-notified bonds are treated as interest income and taxed at the marginal income tax rate of the investor.
On the other hand, gains from notified bonds are treated as capital gains and taxed accordingly.l gains).

Who can issue zero coupon bonds in India?

Zero coupon bonds can be issued by the government (example - treasury bills) as well as corporations/companies (from public as well as private sectors). For example, Muthoot Fincorp Limited issued a zero coupon bond under INE549K07BI5 {link to ISIN} ISIN.

Zero coupon bond rates

Zero coupon bonds are issued at various rates ranging from 3% (short term government zero coupon bonds) up to 10% (long term corporate zero coupon bonds). The rates of zero coupon bonds may vary depending up on the interest rates set by the RBI and the market.

Disadvantages of zero coupon bonds

Zero coupon bonds are subjected to risks that all bonds are subjected to. Some of them are credit default risk, duration risk, interest rate risk and liquidity risk. Apart from credit default risk, other risks can be eliminated by staying invested in the bond until maturity date.

Moreover, zero coupon bonds are more volatile than regular interest paying bonds.

Why would you buy a zero-coupon bond?

The biggest benefit of investing in zero coupon bonds is that they don’t have reinvestment risk.

Another benefit may be that not all investors are looking for regular interest payments and the regular interest payments may actually be a drag on return in a falling interest rate environment. For such investors and conditions, zero coupon bonds are perfect investments.

Why is a zero coupon bond more volatile?

Zero coupon bonds don’t pay interest to the bondholders like normal bonds. Hence, zero coupon bonds are more affected by fluctuations in the interest rates than regular interest paying bonds.

Think about it this way - the interest payments that are already made in normal bonds are not affected by a post facto change in interest rates. But since all the profit is yet to be paid in zero coupon bonds, a change in interest rates affects both, your investment as well as expected profit from a zero coupon bond.

Hence, investors who want to speculate and benefit from a fall in interest rates invest in zero coupon bonds instead of regular interest paying bonds to enjoy a bigger upside if their trade goes right.

Best zero coupon bonds in India

There are a few factors to consider when choosing the best zero coupon bonds for investment. Firstly, credit rating is important. A higher credit rating (AAA or AA) indicates that the issuer is financially healthy to repay your money.

Another factor is yield to maturity (YTM). A higher YTM indicates a higher return that you will generate on your investment. However, credit rating and YTM of a bond are inversely related. Every investor must find his balance between credit rating and YTM to identify the best zero coupon bonds for themselves or under the guidance of a professional.

You should also consider the maturity date of the bond and try to invest in a bond which has a maturity date that aligns with your investment timeline.