What is a Deep Discount Bond? or a Zero Coupon Bond?
Bonds are issued by the Company as a security against the debt raised or loan is taken. Normally bonds are issued with a specific rate of interest. It means the interest payable is at a rate specified at the time of the issue.
For example, A 10-year bond issued with a coupon rate of 6.5% means, the debt is raised payable after 10 years with the interest rate of 6.5% per annum.
Some times, the company does not want to pay interest every month but to pay a lump sum at maturity. That time the company issue a bond at a deep discount, which is without any interest and also called as Zero-coupon bond. It is called a Deep Discount bond or Zero Coupon Bond. The difference between the Maturity amount received and the purchase price is an Income to this type of Bondholder.
Let’s understand this with an Example :
Example 1 :
A Bond is issued for ₹ 730 with a maturity amount of ₹ 1,000 at the end of 5 years.
It means purchases purchase this bond at ₹ 730 (at discount) & will get ₹ 1,000 at maturity, at the end of 5 years.
Now the question comes, what will be the rate of interest or coupon value earned on this bond considering Annual compounding?
Zero-Coupon Bond Formula :
Put it in excel as below,
=((1000/730)^(1/5)-1)*100 => It will give the rate of interest is @ 6.50 %.
Example 1 :
A bond having face value or Maturity value of ₹ 2,500 is due to maturity in 3 years. And an investor wants the return @ 8% p.a. Then how to find out the reasonable purchase price now? It will be calculated with the below formula.
Investment Price = Maturity value / (1 + Expected rate)Number of Years
= 2,500 / (1+.08)3 = ₹ 1,985
It means this bond can be purchased at ₹ 1,985 for an expceted rate of return @ 8% p.a. due for maturity in 3 years with an maturity amount of ₹ 2,500.
