Zero-coupon bonds have become popular this financial year. Several non-banking finance companies have issued zero-coupon bonds through private placements.

As per the bidding platforms of the BSE and the NSE, a total of ₹122.90 billion was raised so far in 2022–23.

Raising funds through these instruments helps issuers make a bullet payment at maturity with no interest payments in between.

Financial institutions typically issue zero-coupon bonds for short- to medium-term maturity.

Some examples of short-term or less than 1-year sovereign zero-coupons include Treasury Bills and Cash Management Bills.

What Are Zero-Coupon Bonds?

As the name suggests, the bonds that do not offer any coupon or periodic interest payments are called zero-coupon bonds. Zero-coupon bonds are discounted instruments or issued at a discount to the face value of the bond. They are redeemed at face value of the bond at the time of maturity.

The difference between the discount on the face value of a zero-coupon bond at the time of issue and the face value paid at the time of maturity is the amount of return earned by an investor.

For example, ABC Company issues a zero-coupon bond with a face value of ₹1,000 and offers investors a discount on its face value, i.e., ₹990, for the zero-coupon bonds maturing in three years. In this case, the investor pays ₹990 at the time of the issue and will receive the total face value of ₹1,000 at the end of the maturity period, essentially earning ₹10 per bond.

These bonds have a single cash flow and a bullet payment at maturity.

Types of zero-coupon bonds

T-Bills and Cash Management Bills: The Government of India issues shorter-tenure debt instruments such as T-Bills and CMBs to manage short-term requirements. T-bills have a tenure of 91 days, 182 days, and 364 days, while CMBs have maturities of up to 91 days.

These instruments are offered at a discount of their face value through the regular auctions conducted by the RBI, and a full-face value is paid to the investors at the maturity of the instruments.

Deep Discount Bonds: When zero-coupon bonds are issued at a high discount to their face value, they are referred to as "deep discount bonds." For example, if an issuer offers a discounted price of ₹890 while its face value is ₹1,000, it is considered a deep discount bond.

Deep discount bonds typically have a discount of 20% or more with a relatively longer maturity. Infrastructure companies generally issue such bonds as their gestation period is very long.

STRIPS: These bonds have a coupon and a principal amount, but the coupons can be stripped off and traded separately in the secondary market.

Deferred Coupon Bonds: This type of bond is a mix of coupon-paying and zero-coupon bonds. In the initial years, these bonds may not pay any coupon, but after a few years, they offer a high-interest rate. These bonds are generally issued by start-ups and infrastructure projects with long gestation periods.

Zero-Coupon Bonds: Pricing

As there are no coupon or interest payments for zero-coupon instruments, they have a single payment at maturity. The yield to maturity of these bonds is calculated as follows:

(Face value divided by current market price)One year (to maturity)

For zero-coupon securities maturing in less than one year, such as T-Bills, the following formula is used:

(Face value- purchase price/par value) * (365/ days to maturity)

Zero-Coupon Bonds - Benefits and Risks

These bonds benefit issuers such as governments and infrastructure companies with a long gestation period and whose revenues can be realised only after the projects.

Zero-coupon bonds offer a good return to investors on maturity while also keeping an option open to sell in the secondary market when interest rates decline sharply and book profits increase due to a rise in prices.

A few professional traders also use Zero-coupon bonds as hedging instruments. When the RBI cuts rates quickly, the price of Zero-coupon bonds can go up.

Zero-coupon bonds are bonds that do not pay any interest or coupon during their term, as indicated by their name. Thus, any income from capital appreciation would emerge solely upon redemption or transfer of the bond in question.

A major risk factor with zero coupon bonds is the interest rate risk if they are sold before their maturity date. The sensitivity of long-term zero-coupon bonds to interest rates also exposes an investor to duration risk.

Duration risk is the risk associated with the sensitivity of a bond's price to a one-percentage-point change in the rate of interest.

Zero coupon bonds with longer tenure issued by corporates with lower credit ratings are considered high-risk bonds and fall under the category of Junk Bonds.

Sources: Reserve Bank of India, National Stock Exchange, BSE, Media Reports