Zero-Coupon Bond: Features, Example and Taxation

Investors seeking fixed returns without regular payouts often consider zero-coupon bonds. Unlike traditional bonds, they do not pay periodic interest but are issued at a discount and redeemed at face value. This blog explains how zero-coupon bonds work, their features, pricing, benefits, drawbacks, and taxation in India.

What Is a Zero-Coupon Bond?

A zero-coupon bond is a debt security that does not pay periodic interest (also called a coupon). Instead, it is sold at a discount to its face value and repaid in full at maturity.

For example, a bond with a face value of ₹1,000 might be sold for ₹700. At maturity, the bondholder receives ₹1,000, earning ₹300 as the effective return.

These bonds are ideal for investors who do not need regular income and prefer a lump-sum payout in the future.

How Zero-Coupon Bonds Work

Zero-coupon bonds work on the principle of discounting. The investor pays less than the face value upfront. Over time, the bond increases in value, and the difference between the purchase price and the maturity value is the investor's return.

The maturity period can range from a few years to over 10 years, depending on the issuer. Government bodies, public sector companies, and some private firms issue these bonds.

The absence of periodic interest makes them less attractive for regular income but suitable for long-term financial goals like children’s education or retirement.

Features of Zero-Coupon Bonds

Here are the main features:

• No Periodic Interest: Unlike regular bonds, these do not offer annual or semi-annual payouts.

• Issued at a Discount: Sold below face value and redeemed at par.

• Fixed Maturity Value: Known return amount at the time of purchase.

• Low Price Volatility (if held till maturity): Though sensitive to interest rate changes in the market, they are risk-free if held until maturity.

• Issued by Governments or Institutions: RBI, NABARD, and other entities may issue such bonds in India.

• Low Liquidity: Secondary market trading may be limited.

How is the Price of Zero Coupon Bond Calculated?

The price of a zero-coupon bond is calculated using the present value formula:

Where:

• r = annual yield or interest rate

• n = number of years till maturity

Example:

If a bond has a face value of ₹1,000, matures in 5 years, and the yield is 8%, then:

Price = ₹1,000 / (1 + 0.08)^5 = ₹1,000 / 1.4693 ≈ ₹680.58

The investor pays ₹680.58 and receives ₹1,000 after 5 years.

Advantages of Zero-Coupon Bonds

• Predictable Returns: The investor knows exactly how much they will receive at maturity.

• No Reinvestment Risk: Since no interest is paid during the tenure, there’s no need to reinvest periodic income.

• Good for Long-Term Goals: Ideal for saving towards education, marriage, or retirement.

• Lower Initial Investment: Entry price is lower than the face value.

Disadvantages of Zero-Coupon Bonds

• No Regular Income: Not suitable for those seeking monthly or yearly income.

• Interest Rate Risk: Market value drops if interest rates rise (though not a concern if held till maturity).

• Tax on Accrued Interest: Even though interest is not received yearly, it may still be taxable each year.

• Low Liquidity: Fewer buyers and sellers in the secondary market.

Example of a Zero-Coupon Bonds

Suppose an investor buys a zero-coupon bond with a face value of ₹1,00,000 for ₹60,000. The bond matures in 10 years.

At the end of 10 years, the investor receives ₹1,00,000. The effective return is ₹40,000 over the investment period.

Such instruments are useful for investors who want a fixed amount at a specific future date without worrying about market fluctuations.

Taxation of Zero-Coupon Bonds in India

In India, the taxation of zero-coupon bonds is governed by the Income Tax Act.

For Listed Bonds:

• Taxed as capital gains.

• If held for more than 12 months: Long-Term Capital Gains (LTCG) tax applies at 10% without indexation.

• If held for 12 months or less: Short-Term Capital Gains (STCG) tax applies as per individual’s income slab.

For Unlisted Bonds:

• Minimum holding period for LTCG is 36 months.

• LTCG is taxed at 20% with indexation.

• STCG is taxed as per slab.

Investors should check whether the bond is listed or unlisted and plan accordingly.

Also, some zero-coupon bonds may require annual reporting of accrued interest as income, even if no payment is received. This depends on whether the bond is treated as a deep discount bond.

It is best to consult a tax advisor for accurate guidance based on the specific bond.

Conclusion

Zero-coupon bonds offer a clear and predictable way to grow wealth over time without the complexities of reinvesting periodic income. While they may not be ideal for everyone, they suit those with specific long-term goals.

Investors should weigh the benefits of a lump-sum payout against the lack of regular returns and possible tax implications. With proper planning, zero-coupon bonds can be a valuable addition to a diversified investment portfolio.