Zero-Coupon Bonds in India

Zero coupon bonds are bonds that don’t issue coupons at regular intervals and instead are sold at a discount from their face value and repaid in full at maturity. They don’t incur interest like other types of debt instruments do and offer a relatively less vigilant approach to bond investors looking for long-term investments.

For example, you purchase a ZCB whose face value is ?1,000 at a discounted rate of ?750, for a term of 10 years. At maturity, you receive ?1,000, which is the face value of the bond. Your return is the difference and is defined at the time of purchase itself without any variations.

Taxation on Zero Coupon Bonds in India

Usually, bond coupons are taxed depending on the term they’re being held for, with anything above twelve months being treated as a long-term capital gain (LTCG) and taxed at 12.5% without indexation. For terms below twelve months, the tax is slapped at an investor’s income slab rate. But zero coupon bonds, as the name suggests, have no coupons. So how exactly are they taxed?

Enter imputed interest, also known as phantom interest. Your gains on a zero coupon bond aren’t periodic and recurring but a lump sum at maturity. Imputed interest is simply the calculated value by which the bond increases every year.

Investors are taxed depending on whether the bond is notified or non-notified. Notified ZCBs are taxed once at maturity, and since they are issued for longer terms, the gains fall under the bracket of LTCG. Non-notified ZCBs are taxed annually based on the investor’s slab rate.

Who issues Zero Coupon Bonds in India?

Zero coupon bonds in India are primarily issued by government-backed institutions and PSUs. Private corporations have also been known to issue them, but such instances have been few and far between.

Benefits of Zero Coupon Bonds

• Since there are no timely coupons, zero coupon bonds investors enjoy the privilege of not having to look for reinvestment opportunities every time a coupon knocks on their doors.
• When you purchase a zero coupon bond, the payout you’ll receive at the end of the term is predefined and doesn’t waver with market sentiments.
• They offer a low investment capital threshold. You get to invest less as you buy them at a discounted price.

Risks to Consider Before Investing

• Zero coupon bonds, by their nature, are subject to duration risk, which is the measure of a bond’s sensitivity to changes in market interest rates. The inverse rule of bond prices and market interest rates (Market rates go up, bond prices go down, and vice versa) comes into effect, but only if you decide to sell them before maturity. 
• As for any long-term investment, inflation can prove to be a threat to your expected returns. Make sure you include this in your deliberations before investing.
• Not all zero coupon bonds carry the same default risk, which means if the issuer defaults before the bond term ends, you might end up losing all your money. Do a thorough background check to see who issues the bonds (corporate or institutional) and where they stand vis-à-vis credit ratings and financial history.

Who Should Invest in Zero Coupon Bonds?

Choosing to invest in zero coupon bonds depends entirely on your financial goals. If you are someone who-

• Has a long-term goal in mind, like buying real estate, starting a college fund for kids, accruing retirement pool money
• Would rather receive a premeditated payout at the end of a long term rather than being paid a varying sum from time to time
• Is expecting the interest rates to fall and would like to offset the concurrent downfall with a big-picture calculated risk

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