Bonds have been around much before shares were available to investors. Companies used to raise funds with a written guaranty of the promise to pay it back in full with interest. This guarantee is known as a bond. In India, bonds can be broadly classified as Government Bonds and Corporate Bonds.
What is a zero coupon bond?
A coupon is the periodic interest received by the bondholder from the time of issuance of the bond till maturity. Zero coupon bonds are those which do not pay any interest to the bondholders. They are offered at a large discount on the face value of the bond. On maturity, the bondholder receives the face value of his investment. In simple words, the investor purchasing a zero coupon bond profits from the difference between the buying price and the face value, contrary to a coupon-based bond which provides regular interest.
Who should invest in a zero coupon bond?
The basic definition of these bonds indicates the absence of regular interest payments to investors. You must keep that in mind before opting for them.
These are ideal for people who would require funds at a specific period of time in the future like children’s education or retirement or a planned tour. Also, if you are not interested in watching the market trends and like the comfort of the ‘invest and forget’ strategy, then you can consider zero coupon bonds.
If your investment portfolio primarily consists of growth investments and you are looking to add diversity to it, then zero coupon bonds can help you secure a guaranteed return for a fixed time period. Finally, these bonds tend to offer great discounts for longer tenures of investment and are perfect for long-term investment plans.
What are the advantages of zero coupon bonds?
Bonds are usually compared with other fixed income options by investors looking for minimal risks. As compared to other fixed income options, these bonds offer good returns on maturity while keeping the option of selling them on the secondary market open, if the interest rates decline sharply. Another important feature of notified zero coupon bonds is that investors do not have to pay any tax on interest since the bonds are issued at a discounted price and redeemed at face value. They are only subject to capital gains tax.
How is income from these bonds treated?
As mentioned above, investors of notified zero coupon bonds issued by NABARD and REC are liable to pay only capital gains tax on maturity. Capital appreciation in such cases is the difference between the maturity price and purchase price of the bond.
In case of non-notified zero coupon bonds, the difference between maturity and purchase price is treated as interest and taxed accordingly.
Like the growth market, the fixed income security market should be approached with a clear understanding of your investment goals and horizon. Zero coupon bonds can work wonders if used meticulously and in sync with your investment objectives.