Zero-Coupon Bonds: All You Want To Know

Zero-coupon bonds suit investors with long-term goals such as retirement or education planning.

Zero-coupon bonds do not pay periodic interest. Issuers sell them at a discount to face value and redeem them at par on maturity, so investors earn returns entirely through price appreciation.

"In zero-coupon bonds, there are no interim cash flows; the entire return is realised at maturity," says Tushar Sharma, co-founder, Bondbay.

Lock in returns

Zero-coupon bonds offer clarity of returns.

"Investors know exactly what they will receive at maturity, provided there is no default," says Sharma. Investors can target a defined lump-sum amount on a future date.

"The yield gets locked in at purchase when the bond is held till maturity," says Vishal Goenka, cofounder, Indiabonds.com.

The absence of periodic coupons eliminates reinvestment risk, which arises when investors receive payouts and must reinvest them even when prevailing rates are unattractive.

Interest rate, liquidity risk

Zero-coupon bonds carry high interest-rate sensitivity.

"Since all cash flows are at maturity, prices can fall sharply if yields rise," says Sharma.

Credit risk also exists.

"Credit risk is issuer-specific as risk profile varies significantly across issuers," says Goenka. Liquidity can remain constrained, especially in non-AAA issuers.

Though these bonds are listed, thin secondary market trading can make exits before maturity difficult.

"Investors may have to accept price concessions, especially in volatile rate environments," says Sharma.

Rate cycles and zero-coupon bonds

Zero-coupon bonds react sharply to interest-rate movements due to their longer duration.

"In a falling rate environment, they typically outperform coupon-paying and short-duration debt instruments, as their higher duration amplifies price gains," says Amar Ranu, head - investment products & insights, Anand Rathi Share and Stock Brokers.

"However, they are also riskier in rising-rate cycles," says Harsh Vira, chief financial planner and founder, FinPro Wealth.

Taxation of zero-coupon bonds

Zero-coupon bonds are taxed as capital assets rather than as interest-yielding instruments. Gains are taxed as long-term capital gains (if held for more than one year) at 12.5 per cent.

"In contrast, interest from fixed deposits and bond coupons are taxed annually at slab rates, reducing compounding efficiency," says Goenka.

Who should invest?

Zero-coupon bonds suit investors with long-term goals such as retirement or education planning.

"Investors with a clearly defined financial goal and a long investment horizon may go for them," says Ranu.

He adds that they also suit investors in higher tax brackets who do not require regular income. Sharma says investors who can hold these bonds till maturity may consider them.

How to compare bond issues

Investors should compare issues before choosing one.

"Assess issuer credit rating. Also check price sensitivity and secondary market liquidity to avoid forced discounts if an early exit is needed," says Ranu.

"Longer maturities increase interest-rate risk, so evaluate alignment with your investment horizon rather than just yield to maturity," says Vira.

Dos and don'ts

Retail investors should use zero-coupon bonds for long-term, goal-based investing.

"Align the bond's maturity with a specific financial goal and aim to hold it until maturity to realise the full yield without interest-rate risk," says Ranu.

Vira emphasises diversification across issuers to reduce credit risk and cautions against investing money needed in the near term. Goenka suggests opting for AAA PSU issuers.

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Feature Presentation: Aslam Hunani/Rediff