What are Zero coupon bonds ? | UPSC

• The funds raised through issuance of these instruments, which are a variation of the recapitalisation bonds issued earlier to public sector banks, are being deployed to capitalise the state-run bank.
• Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity.
• The difference between the purchase price of a zero-coupon bond and the par value, indicates the investor’s return.

WHAT KIND OF BONDS ARE THESE?

• These “non-interest bearing, non-transferable special GOI securities” have a maturity of 10-15 years and issued specifically to Punjab & Sind Bank.
• These recapitalisation bonds are special types of bonds issued by the Central government specifically to a particular institution.
• Only those banks, whosoever is specified, can invest in them, nobody else.

• It is held at the held-to-maturity (HTM) category of the bank as per the RBI guidelines.
• Since it is held to maturity, it is accounted at the face value (and) no mark-to-market will be there.

ZERO COUPON BONDS ISSUED BY PRIVATE FIRMS

• Zero coupon bonds by private companies are normally issued at discount, but since these special bonds are not tradable these can be issued at par.
• There is a difference between zero coupon bonds issued by other corporates and these.
• Normally zero coupon bonds are issued at a discount, which are tradable also.
• Here, there is no question of trading and these are special types of bonds, which the government issues specifically to a specified person and it’s issued at par.

• The market value of this bonds would be around Rs 2,750 crore.
• Punjab & Sind Bank, by investing in these bonds from held-to-maturity category, won’t have to book mark-to-market loss and will value the bonds at cost, i.e.Rs 5,500 crore.
• The government will infuse Rs 5,500 crore into equity capital of Punjab & Sind Bank.
• By doing so, the capital adequacy of Punjab & Sind Bank goes up by Rs 5,500 crore (instead of Rs 2,750 crore).

ADVANTAGES OF ZERO COUPON BOND

• NO REINVESTMENT RISK : Zero Coupon bonds do not allow any periodic coupon payments and thus a fixed interest on Zero Coupon bonds is assured.
• FIXED RETURNS : The Zero Coupon bond is an ideal choice for those who prefer the long-term investment and earn in lump sum.
• LONG-TIME HORIZON : The long time horizon of the Zero Coupon bond is a significant advantage.A fixed amount can be availed via a long-term investment without worrying about any market turmoil.

DISADVANTAGES

• NO REGULAR INCOME : The Zero Coupon bond provides in a lump sum; therefore, it prevents a regular cash flow. This bond will not benefit investors with the requirement of regular cash.
• INTEREST RATE RISK : Interest rates of this bond can decline over time due to fluctuation in the market. Therefore, the investors will always have interest rate risk if sold before the maturity date.
• ILLIQUIDITY IN THE SECONDARY MARKET : The value of this bond shares a negative correlation with the rise of the interest rate. A rise in the interest rate indicates a decline in the fund value in the secondary market.
• DURATION RISK : Duration risk is related to the sensitivity of the bond’s price to a one percent change in the interest rate. The longer the duration, the more it becomes sensitive to change in interest change.