Zero-coupon bonds (ZCB), also known as deep discount 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, Advantages, and Disadvantages
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 some interest rate and enjoy regular income from them.
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.
Long Term in Nature
These bonds are generally long-term in nature. They are a long-term investment 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, the individual’s long-term goals can be fulfilled using such bonds. 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 payment 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 ZCBs as they are 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. Undoubtedly, 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. The money grows many folds because they are very long-term instruments. 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.