Zero-Coupon Bonds and Strips

Imagine lending money to a friend, but instead of receiving interest payments periodically, you agree to get a single lump sum payment at the end of the loan term.

This is the basic idea behind Zero-Coupon Bonds — bonds that do not pay periodic interest but are issued at a discount and redeemed at face value upon maturity.

What Are Zero-Coupon Bonds?

Zero-coupon bonds are fixed income securities that do not make periodic coupon payments. Instead, they are sold at a price significantly below their face value, and the difference between the purchase price and face value represents the investor’s return. These bonds are particularly sensitive to interest rate changes because all the return is received at maturity.

What Are Strips?

Strips (Separate Trading of Registered Interest and Principal Securities) are created by separating the coupon payments and principal repayment of a bond into individual zero-coupon securities. Each strip can be traded independently, allowing investors to invest in either the principal or individual interest payments.

Key Features:

1. No Periodic Income: Investors receive no interest payments before maturity, which means no regular income but a lump sum payout at maturity.
2. Issued at a Discount: Zero-coupon bonds and strips are sold below face value.
3. Interest Rate Sensitivity: These instruments have higher duration and price volatility compared to regular bonds, making them more sensitive to interest rate changes.

Example:

Suppose the government issues a zero-coupon bond with a face value of ₹1,000 maturing in 5 years, sold today for ₹750. The investor’s return is the difference of ₹250 received at maturity.

Why Invest in Zero-Coupon Bonds and Strips?

• Long-Term Planning: Ideal for investors looking for a lump sum at a future date, such as retirement or children’s education.
• Interest Rate Play: Their sensitivity to interest rate changes can be used strategically in portfolio management.
• Tax Considerations: Although no periodic interest is received, imputed interest may be taxable annually depending on local laws.

In India, zero-coupon bonds and strips are issued by the government and traded on exchanges. They offer investors an option for long-term investments without periodic cash flow but with predictable returns at maturity.

Zero-coupon bonds and strips provide a unique fixed income option for investors focused on future lump sum needs. Their higher sensitivity to interest rate changes requires careful consideration in portfolio construction. Next, we will discuss Municipal Bonds, focusing on bonds issued by local government bodies.