Zero-Coupon Bonds: Pros and Cons

Zero-coupon bonds are those bonds that are sold at a deep discount to their face value. This means that these bonds do not receive any periodic interest. Instead, the investors have to invest a lump sum amount at the beginning of their investment and get paid a higher lumpsum amount at the end of their investment. The absence of regular periodic payments is what makes zero-coupon bonds different as compared to other types of bonds.

Zero-coupon bonds are commonly issued by governments. In this article, we will have a closer look at the pros and cons of zero-coupon bonds from an investor’s point of view:

Pros of Zero-Coupon Bonds

There are many zero-coupon bonds that are already in existence. Also, each year, many new zero-coupon bonds are issued. Despite there being so many zero-coupon bonds, the issues get sold out relatively easily. These bonds are so popular because they have certain advantages. Some of the advantages of these bonds have been mentioned below:

• Higher Yields: Firstly, zero-coupon bonds are perceived as higher-risk bonds. This is because investors pay money upfront and then do not have much control over it. Also, since the money is locked in over longer periods of time, the perceived risk is more. As a result, to compensate the investors for taking higher risks, companies have to pay investors a higher rate of return. This is the reason why zero-coupon bonds have a higher annualized yield as compared to other bonds. This works out to be beneficial for investors who do not have a need for receiving immediate payments.

• No Reinvestment Risk: Zero-coupon bonds do not have any reinvestment risk. This is because the bond does not pay interest periodically. Hence, investors do not receive any cash flow which they have to reinvest periodically. The annualized rate which they receive on the zero-coupon bond is the same rate at which their money will be automatically reinvested. This is the reason that zero-coupon bonds become extremely popular especially during periods when the market yield is high. This is because investors want to lock this high yield over extended periods of time.

• High Liquidity: Zero-coupon bonds have a very liquid market. As already mentioned above, a huge chunk of zero-coupon bonds is already in existence and also new ones are introduced very often. This means that there are a lot of individual investors as well as institutions that are constantly buying and selling zero-coupon bonds. As a result, when any investor wants to sell their bonds, they are able to do so without facing any loss in value. High liquidity means that investors do not have to wait till maturity to reap their gains. They can sell the bonds anytime to obtain their principal as well as accrued interest.

• Easy to Integrate into Financial Plans: Zero-coupon bonds are useful for investors who want a fixed nominal value in the distant future. For instance, people who are planning for their kids' education or marriage can set aside a sum of money right now which will grow and mature into a bigger lump sum at a later stage. This fits into the individual financial plan of many investors which leads to increased demand for these bonds.

Cons of Zero-Coupon Bonds

The pros of zero-coupon bonds are quite well known and often very well-publicized. However, there are some significant cons related to zero-coupon bonds as well. Some of them have been listed below:

• Taxation on Phantom Interest: Zero-coupon bonds do not pay any interest to investors. However, the interest does accrue over the years. Now, investors may have to wait long term to receive their share of the interest. However, governments do not want to wait for receiving their share of taxes. Hence, most governments across the world will charge tax immediately based on the amount of interest accrued. This becomes a double whammy for the investors. Firstly, investors are not paid any money periodically. However, on top of that, they are expected to pay money on the phantom interest which they have earned over that year.

• Higher Risk: It is important to know that companies that float zero-coupon bonds do not have to pay any periodic interest on their money. This often means that these companies tend to make riskier investments. Also, since the bonds have to be repaid long term, there is a huge risk involved that the company may not survive long term. It is for this reason that investors prefer to invest in zero-coupon bonds issued only by government agencies. The risk of survival for such agencies is quite negligible. This is the reason why investors feel comfortable only while lending to government agencies on these terms.

• No Regular Cashflow: Last, but not least, zero-coupon bonds do not provide any fixed cash flows. This means that a large chunk of fixed income security investors who make investments for receiving monthly income are excluded from the market.

The bottom line is that zero-coupon bonds are high-risk financial instruments. The risk reduction of these bonds is done by obtaining a higher yield and also ensuring that money is lent out only to government agencies.