A zero-coupon bond is a discounted investment that helps to serve futuristic goals.

A zero-coupon bond is a type of bond which has no interest to be paid to the bondholders and it trades at a discount to the face value of the bond.

A zero-coupon bond does not pay periodic coupon payments and trades the bond at a deep discount. Time value of money plays an important role.

Time value of money represents that money is worth more now than the same amount is in the future.

For example, an investor would prefer to receive Rs. 100 today than in the future. By receiving Rs. 100 today an investor would invest that elsewhere and earn higher interest thereby earning more than Rs. 100 in a year’s time.

Using a zero-coupon bond in the above example an investor who purchases a bond that does not have periodic coupon payments expects to get a value higher in the future as compared to the value of that identical amount in today’s date. Thus zero-coupon bond trades at a discount to its current value to make it look attractive to investors from a profit perspective.

Calculating zero-coupon bonds

Pricing of the zero-coupon bond= Face value / (1+r)^n

where,

Face value is the maturity value of the bond

R is the interest rate

N is the number of years the bond is issued

The above formula considers the interest rates compounded annually

Price of the zero-coupon bond= Face value / (1+r/2)^nx2

The above formula considers the interest rate compounded semi-annually.

Example: Annual compounding

ABC company issues a bond of Rs.1000 as the face value with 5 years of tenure. The interest rate on the bond is 5% compounded annually.

Price of the bond- 1000 / (1+0.05)^5

Price of the bond today = Rs. 783.53

Semi-Annual compounding

Price of the bond = 1000 / (1+0.05/2)^5x2

Price of the bond today = Rs. 781.20

Payment of interest is the key factor that differentiates between a zero-coupon bond and a regular bond.

A zero-coupon bond is not associated with interest risk as they do not involve periodic coupon payments.

Interest-rate risk is the risk that an investor’s bond will decline in value due to fluctuations in the market interest rate.

For example:

An investor paid Rs.783.53 for a bond with annual compounded interest and if the interest rate rise from 5% to 10%

Price of the bond= 1000 / (1+ 0.10) ^5= Rs. 620.92

If an investor sells a bond immediately after purchasing it there would be a loss of Rs. 162.61 (783.53-620.92)

Zero-coupon bonds are ideal for investors looking for funds required for a specific period of time in the future.

An investor is not willing to be aligned with market trends and seek comfort with the “invest and forget” strategy, zero-coupon bonds have

A zero-coupon bond guarantees a fixed return after a specific period of time, turning out a good investment idea to diversify an investor’s portfolio.

Zero-coupon bonds get away with the tax on interest since these bonds are issued at a discounted price and redeemed at a face value. Investors are likely to pay capital gain taxes.

Capital gains in zero-coupon bonds are the difference between the maturity price of the bond and the price at which the bond is purchased.

Financial takeaway

Zero-coupon bonds pay you a lump sum amount at the maturity date and this key thing is unique about this bond.

However, such bonds provide a clear picture of the details of every aspect associated with them i.e s it helps an investor to know when an investor will receive a return on their investment and the exact amount of return.

It is always important to take guidance from experts before making any investment decisions. Bondskart has a team of experts who will help you every step of the way to ensure you make an informed decision.