Debt security with no interest payments instead trades at a huge difference from the face value which rises to the par at maturity date. Also referred as Deep Discount bonds since they are incomparably cheap.
Some bonds are issued as zero coupon initially, while others are converted in between, where the coupons are combined and paid at par at the date of maturity. The interest return is also called as Phantom interest as the return depends on the purchase price. The difference is the amount paid and no other factors influence the yield.
If an investor thinks the return is fairly easy to calculate, the comfort zone has a clutch, the investor has to pay tax on the capital gains that are unrealized. Since the payment is straight forward, zero coupon bonds will always be issued to avoid yearly cash outflows from the firm issuing the bond. The zero coupon bond yield is calculated using the formula:
10 yr Gsec Zero coupon bond
Longer the bond, the less you pay. The tax is the only concern restricting the investor from buying zeros. Conversationally called as “Zeros“.
Why should I buy a Zero Coupon bond?
Zero coupon bond is a perfect investment vehicle if coupled with well timed future plans. Aligning the foreseeable expense with the maturity year can help fund at the right time. Zero Coupon bonds for college savings is the most appropriate usage for the investor to buy.
Are zero coupon bonds safe?
Zero coupon bonds are no different than other kinds of bond investments. The risk every bond undergoes is the same for zeros. Risk of any kind of debt security is attributed to the financial position of the issuer. If zeros are bought with long term expense in mind, these securities don’t oscillate much as the trading volume would stay diminished so they trade flat.
Are zero coupon bonds taxable?
The tax on zeros would be 10% as they come under Long Term Capital Gain tax (LTCG) only if the security is held for more than a year. Unfortunately, the investor has to pay taxes every year on the accrued interest return. Remember, today’s money is worth more than tomorrow’s.
Are zero coupon bonds risk free?
Municipal bonds, Government bonds, Central Government bonds are all risk free as they are issued by the government. Lowest is the probability that government fails to repay. By buying municipality issued bonds, the investor can avoid paying tax.