What is a Zero Coupon Bond?

A zero coupon bond is a type of debt instrument; it is also called an accrual bond. In this bond, periodic interests are not paid to the bondholder. Instead, it is usually issued at a substantial discount on its face value. When this bond matures, it is generally redeemed at its full face value, and the bondholder earns their gains. Here, the difference between the purchase price and the maturity value represents the investor's gain. This article explains in detail what is zero coupon bond.

How Zero Coupon Bonds Work? 

Having understood zero coupon bond meaning, let's understand how it works: 

• Purchase at a Discount: A zero coupon bond is purchased at a price significantly lower than its face value. For instance, a bond with a face value of ₹25,000 maturing in 18 years with a 6% yield may be available for approximately ₹8,750. The discounted price reflects the absence of periodic interest payments. 
• No Periodic Interest: Unlike traditional bonds, a zero coupon bond does not provide regular interest payments to the bondholder. The bond does not distribute any income during its tenure. Investors receive no cash flow until the bond reaches its maturity date. 
• Maturity Payment: At maturity, the bondholder receives the full face value of the bond. Using the previous example, the investor who purchased the bond for ₹8,750 will receive ₹25,000 at the end of 18 years. The entire return is realised in a single payment. 
• Investor Gain: The gain earned by the investor is the difference between the purchase price and the maturity value. In this zero coupon bond example, the difference of ₹16,250 represents the total return. This return comprises the principal invested plus interest that compounds automatically until maturity. 

How is the Price of Zero Coupon Bond Calculated? 

The price of a zero coupon bond can be computed by using a simple formula. 

Formula for Annual Compounding: 

The price of a bond can be determined by using the formula:  

Bond Price = Face Value / (1 + r)^n 

What each symbol means: 

• Face Value: The amount bondholder receives at maturity. 
• r: The interest rate or required rate of return 
• n: This is the total number of years until bond maturity. 

Formula for Semiannual Compounding: 

Price of bond = Face value / (1 + r/2)^(n×2) 

• The formula changes slightly when interest compounds twice a year.  
• The interest rate (r) gets divided by 2.  
• The number of years (n) gets multiplied by 2.  
• This adjustment accounts for the bond compounding every six months instead of once a year. 

The second formula is more common because most zero coupon bonds compound semi-annually. Dividing the rate by 2 gives the half-yearly rate. Multiplying the years by 2 gives the total number of compounding periods. 

Advantages and Disadvantages of Zero Coupon Bonds 

Zero coupon bonds generally provide various advantages and some limitations, such as: 

Who Should Consider Zero-Coupon Bonds for Investing? 

Investors looking for a lump sum amount at a future date may find zero coupon bonds appropriate. Usually, there is no periodic income from such bonds. They could also be suitable for investors in higher tax brackets. The returns are generally in the form of capital gains and not interest income. Long-term capital gains on listed bonds usually attract reduced rates of taxes and, therefore, result in improved tax efficiency for a certain category of investors. 

Conclusion 

A zero coupon bond is a debt instrument that can be issued at a discount on its face value. These bonds do not pay periodic interest throughout their term. The bondholder usually gets the entire face value at maturity. The price may depend on the interest rate and time to maturity. These bonds can have their set of advantages and disadvantages, depending on various investor profiles. Those investors looking for lump-sum amounts at a future date may consider this avenue. Investors can use an online trading app for easy access to bond markets.