The zero coupons bonds are generally issued by Public sector undertakings, Infrastructure companies, Banks, Financial institutions, Government bodies for various development purposes like setting up the plant, launching the new projects or for the expansion of the business. So, whenever you buy a bond it means that you are lending your money to the institution for its expansion and the growth and in return you receive the appreciated amount after a certain period of time.
Understanding it with the help of an example
The XYZ Ltd has a face value of its Zero Coupon Bond at Rs. 10,000 and is issuing this bond to the public at the discount rate of Rs. 7,000 with a maturity period of 5 years. With the help of the following formula, you can calculate the effective yield or per year return on the bond.
The effective yield can be calculated as follows:
Zero coupon bond yield = (Face value/ Discount value)1/n - 1
Now, the greater is the duration of the maturity, the less is the amount that investor pays for the bond. If the XYZ limited pays you Rs. 10,000 in 20 years of time instead of 5 years with the same yield of 7.39 %, then you will pay,
= Rs. 10,000/ (1+0.0739)20
= Rs. 2401
When the bond matures after 20 years you will receive Rs. 10,000 and the interest income add-up via gradual appreciation of the money that you have invested initially.
Horizon of zero coupon bonds
The zero coupon bond is a suitable investment option for the long term horizon; therefore, it is appropriate for those who can invest the money for the longer duration without any plans to touch or withdraw the amount. It can be an ideal solution for your long term financial goals like higher education for your children, marriage or the retirement planning. It helps you grow the small amount in a good one after a period of time.
Low amount of investment
The zero coupon bonds can be purchased or are available in denominations as low as Rs. 1,000 per bond with no upper limit. The Kisan Vikas Patra by Indian Post is an example of Zero coupon bond. Therefore, the zero coupon bond can become the asset of almost all the income groups.
Protection from the re-investment risk
This tool provides the opportunity to lock your investment for the specific period of time without worrying about the interest rate volatility while the other assets whose returns are linked to the interest rates may fluctuate with the variations in the prevailing rates. In the case of the zero coupon bond, the maturity amount will remain the same irrespective of the prevailing interest rates.
Wide range of maturity period
The zero coupon bonds come with different maturity period, you can invest in 3-year maturity bond, 5-year maturity bond or a 20-year maturity bond depending upon your investment horizon and the financial goals.
Assessing the credit risk
As you will receive your maturity amount after a long period of time with no interest income in between therefore it becomes very important to assess the credibility and the risk associated with it. Therefore, the grading of the issuer by the rating agencies should be scrutinized carefully before buying any of the zero coupon bonds. Generally, a rating at par or above “AA” is considered safe to invest in the bond.
Are zero coupon bonds meant for you?
After going through the basics of the zero coupon bonds you should now evaluate the proportion of these bonds that must be added to your investment portfolio that can provide enough stability against the interest rate fluctuation in the money market. You can consult your financial adviser for this purpose.
The investment in the zero coupon bonds protects your investment portfolio from the interest rate volatility by offering you the fixed maturity amount after a certain period of time. It is an investment tool for those investors who are not keen on the regular income but focused on having a good amount after a period of time. By adding these in your investment portfolio you are actually taking a step closer towards offering stability to it.