What is a Zero Coupon Bond? Everything You Need to Know

A bond without any interest or coupon rate, issued at discount, is known as a zero-coupon bond. It is a popular investment option to earn lump sum returns at the end of maturity as the frequent interest payments are absent. Here, the bond’s face value is its price at redemption. 

Zero-coupon bonds are unique due to their features and pricing. Investors can earn significant gains due to discounted purchase prices and redemption at face value. During the investment, investors should analyse the nature of these bonds, their pros and cons, pricing, etc., to decide their suitability. 

What is Zero-coupon Bond?

The debt instrument without any interest rate is known as a zero-coupon bond. These assets help investors earn a lump sum amount at maturity. Due to no coupon, investors do not earn regular interest on the investment. However, these bonds are issued at a discount and redeemed at face value, which helps investors gain the difference.

Investing in zero-coupon bonds can protect the investment in the long term. Investors willing to wait up to the maturity period can earn a fixed gain based on their purchase price. 

How does it work?

A Zero-coupon bond meaning is associated with no interest payment above the decided face value. 

• It is initially issued and traded in the market at discounts. It is redeemed at the face value. 
• Usually, due to the long duration of these bonds, the discount is also high. Therefore, these bonds are also known as ‘deep-discount bonds’. 
• Therefore, the purchase price and the face value difference is the gain for the investors if they are invested till maturity. 

The market forces decide the pricing for a zero-coupon bond, which helps calculate the yield to maturity.

How To Yield-to-Maturity of a Zero-coupon Bond

YTM, or yield to maturity, is the indicator of the expected returns earned per annum if the investment is held up to maturity. However, the difference between the face value and discounted purchase price helps determine the expected YTM for a zero-coupon bond. 

Step 1: Use the formula for YTM calculation.

YTM = [((F.V./P.V.)^(1/N)) – 1]*100

Here,

F.V. = Face Value that will be earned at maturity.

P.V.  = Purchase Value of a bond.

N = No. of years up to maturity.

Step 2: Insert the values according to the inputs.

Step 3: The result will present the YTM at that moment of time. Investors can frequently calculate for better understanding.

Understand with Hypothetical Example

Mr K purchased a zero-coupon bond worth ₹935, which has a face value of ₹1000. The bond will mature after 4 years. Therefore, its YTM will be:

YTM = [((F.V./P.V.)^(1/N)) – 1]*100
Face Value	1000
Purchase Value	935
N or years up to maturity	4
YTM	[((1000./935.)^(¼)) – 1]*100
YTM	1.69%

Therefore, Mr K can assume that if these bonds are held up to maturity, then he earns 1.69% interest every year over his investment. 

Benefits and Drawbacks

Understanding what a zero-coupon bond is may not be sufficient. Therefore, evaluating the pros and cons of investing in zero-coupon bonds can help investors decide their suitability and allocation.

Benefits	Drawbacks
Usually, these bonds generate potential returns. The embedded annual returns can be calculated with YTM.	Lack of a fixed interest rate causes high volatility in the zero-coupon bond pricing.
Reinvestment risk is eliminated due to redemption at face value.	Investors do not get frequent incomes in the form of interest. Only a lump sum amount is gained at maturity.
Investors can get deep discounts on such bonds.	These bonds have a long maturity period.

Suitability for Zero-coupon Bond

A zero-coupon bond meaning has a unique scope and investors need to understand its functioning to invest in such bonds. Here are some factors that can help investors consider a potential investment opportunity in such bonds:

• These bonds have a long maturity period. Moreover, it doesn’t generate regular income. Therefore, it may not suit investors with a short-term objective. 
• Check whether investment objectives align with the investment. 
• The risk profile of the investors should be analysed before investing in zero-coupon bonds. Risk-averse investors can earn fixed returns if bonds are held up to maturity.
• Analyse the current portfolio before deciding the allocations in these bonds.

Conclusion

A zero-coupon bond is an instrument that does not prescribe to offer any gains in form of interest or coupon rate. Usually, investors purchase these bonds at a discount price, which are later redeemed at face value during the maturity. Moreover, these bonds can be a suitable investment for investors with long-term prospects as the prices, affected by market forces, can fluctuate significantly.To learn more about unique financial concepts, log in to PowerUp Money or download its financial management app today!