Investing has many important aspects to know and understand. There are so many kinds of securities available in the market, and it can be difficult to choose any of them and stay on top in the investment market. You have probably heard of bonds before, but what about a zero-coupon bond?
Do you want to know how they work and what to keep in mind? This blog will tell you everything, from what they are to their formula, features, risks, and more.
What are Zero-Coupon Bonds?
In the past, businesses would raise money from investors using a written guarantee. The term “bond” refers to this written assurance. Bonds with a coupon schedule regularly distribute coupons or interest.
Zero-Coupon bonds, or discount bonds, are purchased at a discount and pay no interest or periodic interest to the fund’s owners. The amount of money invested in Zero Coupon Bond does not generate regular interest during the tenure. The annual return on capital is included in the face value and paid to the investor at maturity. Therefore, investors receive a sum of money at the end of the term.
For example, a Rs. 20,000 face value zero-coupon bond of tenure 20 years with an interest rate of 5.5% might sell for about Rs. 7,000. The investor will receive a lump-sum payment of Rs. 20,000 at maturity, representing Rs. 13,000 return on investment. In this case, the profit comes from interest that automatically compounds until the bond matures.
How are Zero Coupon Bond prices calculated?
The value of the zero coupon fund can be calculated either on an annual basis or a semi-annual basis. The following two formulas can be used to calculate the annual and semi-annual zero coupon bonds:
The formula for calculating the price of the bond annually:-
Price of the bond = Face value/ (1+ r) n
The formula for calculating the price of the bond semi-annually:-
Price of the bond = Face value/( 1+ r/2) n*2
In both the formulas:
Face value = Future value or maturity value of the bond
r = Required rate of return or interest rate
n = Number of years until maturity
In both formulas, the required rate of return (r) is divided by two, and the number of years until maturity (n) is multiplied by two to calculate the bond’s price semi-annually.
Benefits of Zero-coupon bonds
1. Low-interest rate risk:– Zero coupon bonds have no reinvestment risk because there are no ongoing interest payments. Reinvestment of interest payments is not necessary because there are no interest flows. In a setting of falling interest rates, this may be advantageous.
2. Predictable results:- Since the zero-coupon bond’s purchase price and maturity value are known in advance, you can accurately predict its return. You can confidently forecast the bond’s return in advance if you hold it until it matures. Therefore, risk-averse investors can invest in such bonds.
3. Long-Term Investment with fixed returns:- If the goal is to invest for the long term and earn a lump sum return, investors can purchase zero coupon bonds. For investors without regular income needs, zero-coupon bonds are the perfect investment.
Such investors may find the appreciation in zero-coupon bonds appealing because they can purchase zero-coupon bonds at a significant discount.
The Risk Involved in Zero Coupon Bonds
Despite having many advantages, the Zero Coupon bond has a few disadvantages as well, which are mentioned below:
1. No regular income:- The Zero Coupon bond provides a lump sum amount after the maturity date, preventing regular cash flow. This bond will not benefit investors with the requirement of regular cash.
2. Interest Rate Risk:- Interest rates of this bond can decline over time due to fluctuation in the market. Therefore, the investors will always have interest rate risk if sold before maturity.
Zero-coupon bonds are the best type of investment for people who want to put money aside for extended periods without receiving a regular income. These bonds are appropriate for risk-averse investors. They are perfect for those who want to make long-term investments and receive their return in a lump sum when they mature. Zero-coupon bonds are a better investment option if the investment aims to generate consistent income or interest.