Zero-Coupon Bonds – Features, Types, Advantages & Disadvantages

What are Zero Coupon Bonds?

Zero-coupon bonds (ZCB), also known as deep discount bonds. These bonds do not carry any coupon rate. They are issued at a discount and redeemable at par. The amount of discount is equal to the total return for the investor. This can be expressed in terms of interest rate, called the implicit or inherent rate of interest. Typically, the prevailing market rate of interest forms the basis of the implicit rate of interest on zero-coupon bonds by the issuers.

Features of Zero Coupon Bonds

The following are the characteristics of ZCBs:

Zero-Coupon

The basic difference between other normal bonds with coupon rates and zero-coupon bonds is the coupon rate only. ZCBs carry no interest rate, whereas other bonds carry a certain interest rate and enjoy regular income from them.

Return of Investors

As discussed earlier, the return for investors in the case of a zero coupon bond is equal to the difference between its issue price and redemption price.

Maturity Period

ZCBs are issued for a minimum period of 10 years.

Types of Zero Coupon Bonds

The following are the types of ZCBs:

• Treasury Strips
• Corporate ZCBs
• Municipal ZCBs
• Zero-coupon convertibles
• Recapitalization bonds

Advantages of Zero Coupon Bonds

Let us look at some of the reasons why an investor should invest in ZCBs.

Long-Term in Nature

These bonds are generally long-term in nature. They are long-term investments by the investors, and on the other hand, they are long-term sources of finance for the issuer. Investors can best utilize such zero-coupon bonds to plan for their children’s education, retirement, etc. In essence, it is a source to fulfill the individual’s long-term goals. This attribute is advantageous to both the issuer and the investor.

Conservation of Cash

From the company’s point of view, they can preserve the cash with them in the case of ZCBs. If they had issued normal bonds, interest payments every year would have been compulsory. For the company, these regular payments are exempt in case of ZCB issues.

No Reinvestment Risk

This feature focuses more on the investors. There is no reinvestment risk for the investors in zero coupon bonds as they get automatically reinvested at the implied interest rate. In the case of bonds paying regular interest to the investor, they will have to think of investing that money again. They may not be able to invest at a higher interest rate than the implicit interest rate of ZCBs.

Disadvantages of Zero Coupon Bonds

Before opting to invest in ZCBs, an investor should be well aware of its drawbacks too. Let us learn about some of them.

Taxability

The return of a ZCB investor is long-term capital gain, whereas, for other normal bonds, it is an interest income. Normally, long-term capital gains are exempt from the tax, which benefits the investor. In a few countries, they treat part of the capital gain as taxable, and in some others, the accrued interest is taxable. This is also a disadvantage for ZCB investors.

Loss of Interest

Since there is no reinvestment risk in such types of bonds, but, there can be a loss of profit in the increasing interest rate regime.

Highly Fluctuation Market Prices

Market prices of zero-coupon bonds are prone to higher fluctuation than other coupon-paying bonds because they do not pay any interest during their lifetime.

High Repayment Risk

A company or government issuing zero-coupon bonds is at a high risk of repayment because the amount to be paid is huge. Effectively, the amount includes the money they actually received from the investors at the time of issue and the compounded interest on that money. Money grows many folds because they are a very long-term instrument. It has an inherent risk of repayment for investors and risk of bankruptcy for the issuer company or any other body.

Read about various other Types of Bonds here.