What is a zero coupon bond?
A zero-coupon bond is an investment that pays no interest during its term. Instead, the investor buys the bond at a lower price than its face value, which is the amount it will be worth when it matures. The difference between the face value and the purchase price is the interest that the investor earns from the bond. Basically, the investor buys the bond at a lower price than its face value and gets the face value when the bond matures. The investor saves money by paying less for the bond and earns interest by getting more money at the end.
Understanding Zero Coupon Bond
A zero-coupon bond does not pay any interest to the investor. Instead, it is sold at a lower price than its face value (face value is the amount the investor will entitled to receive when the bond is matured). For instance, if you buy a zero-coupon bond with a face value of ₹1,0000, that matures in 10 years. The bond is being sold at a price of ₹5000, meaning that you will pay ₹5000 today to buy the bond. After 10 years, you can redeem the bond for ₹1,0000, which means you will make ₹5000 as your profit. The difference between the purchase price and the face value is the implied interest that you earn from holding the bond. Zero-coupon bonds attract investors who want to save money for a long-term goal. In spite of that, zero coupon bonds also have some disadvantages, such as being subject to income tax on the implied interest and being more sensitive to changes in market interest rates