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What is a Zero Coupon Bond?

12 May 2022 0 COMMENT

Introduction

Fixed income instruments are attractive investments for those who want stable returns. Bonds are popular fixed income instruments issued by governments and corporations. Zero-coupon bond is a  type of bond that governments and companies issue. 

Zero-coupon bonds, unlike other bonds, do not give investors a regular interest pay-out. Instead, they are issued at a steep discount to the bond’s face value at the time of issuance. That is why they are also called discount bonds. At maturity, the investor receives the entire face value. The difference between the invested amount and the face value is your return as an investor. 

Additional Read: Stocks v/s Bonds – A quick guide

Pricing of a Zero Coupon Bond 

The formula used to calculate the price of zero-coupon bonds is:

Price = Face Value/ (1+r)^n 

Where r is the annual return, and n is the number of years until maturity. 

Why invest in a Zero Coupon Bond

1. Returns are predictable 

The most significant advantage of a zero-coupon bond is that the returns that you receive on them are known in advance. You buy the bond at a discount on the face value, and you know the maturity amount you will get at redemption. However, yield could vary if you sold the bond in the open market before maturity.

2. There is no reinvestment risk 

Reinvestment risk refers to the financial risk of reinvesting pay-out, like periodic interest amount, you get on an investment. There is a possibility that the rate of return may be lower at the time of pay-out and you invest that amount at a lower interest rate. Since zero-coupon bonds do not offer regular returns, reinvestment risk is eliminated. 

3. Can help meet financial goals 

Since the maturity amount and returns are known, zero-coupon or discount bonds are ideal for short-term to long-term investment goals if you have a low-risk appetite. You can plan for investments goals with these bonds as you know the exact amount you will get on maturity.  

4. Easy liquidity 

Zero-coupon bonds are traded in the secondary market. If you don’t want to hold the bond to maturity, you can sell it before maturity on the stock exchange. 

Additional Read: What are the benefits of investing in Bonds?

Should you consider investment in a Zero Coupon Bond

If you are looking to make a lump sum investment and want a maturity amount in lump sum too, you could consider investing in a zero-coupon bond. Also, if you want to avoid market ups and downs, zero-coupon bonds are suitable investments to consider because you are assured of a return. They can also be ideal for portfolio diversification. However, if you are looking for regular income from your investment, zero-coupon bonds are not your investment. 

Additional Read: Lumpsum vs SIP: Know the advantages

Conclusion

Zero-coupon or discount bonds are fixed-income instruments that give you a lump sum amount on maturity. Investors who have a defined investment goal will find it a valuable product to invest in. 


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