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Zero coupon bonds

  Jan 07, 2021

Zero coupon bonds

Q. What is the news?

  • The government has recently used financial innovation to recapitalise Punjab & Sind Bank by issuing the lender Rs 5,500-crore worth of non-interest bearing bonds valued at par. 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.
  • Though these will earn no interest for the subscriber, market participants term it both a ‘financial illusion’ and ‘great innovation’ by the government where it is using Rs 100 to create an impact of Rs 200 in the economy.

Q. What is a Zero-Coupon Bond?

  • A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value. 
  • Some bonds are issued as zero-coupon instruments from the start, while others bonds transform into zero-coupon instruments after a financial institution strips them of their coupons, and repackages them as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price, much more so than coupon bonds. 

A zero-coupon bond is also known as an accrual bond.

Q. What kind of bonds are these?

  • Unlike the previous tranches of recapitalisation bonds which carried interest and were sold to different banks, 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 not tradable, it is not transferable. It is limited only to a specific bank, and it is for a specified period … 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. So these are special kind of bonds issued by the government after proper (due diligence). 
  • Though zero coupon, these bonds are different from traditional zero coupon bonds on one account — as they are being issued at par, there is no interest; in previous cases, since they were issued at discount, they technically were interest bearing.

Q. What is the significance of Zero Coupon Bond? 

  • The market participants term it both a ‘financial illusion’ and ‘great innovation’ by the government where it is using Rs 100 to create an impact of Rs 200 in the economy.
  • The lender has kept the Zero Coupon Bond in the Held-to-Maturity (HTM) bucket, not requiring it to book any mark-to-market gains or losses from these bonds because these bonds are not tradable.
  • The government has found an innovative way to capitalise banks, which does not affect the fiscal deficit while at the same time provides much needed equity capital to the banks.
  • The funds raised through issuance of Zero Coupon Bond can deployed to capitalise the state-run bank.

Q. What are some of concerns associated with Zero Coupon Bond? 

  • Zero coupon bonds are subject to interest rates risk if sold prior to the date of maturity.
  • The value of zero coupon bonds is inversely related to the rise in the interest rates i.e. with rising in interest rates there is a decline in the value of these bonds in the secondary market.
  • The sensitivity of long-term zero-coupon bonds to interest rates exposes them to duration risk which implies that higher a bond’s duration, the greater will be its sensitivity to interest rate changes.

Q. How do they differ from 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.
  • It is an innovation by the government where it is using Rs 100 to create an impact of Rs 200 in the economy. It is issuing a zero coupon bond aggregating to Rs 5,500 crore at par to Punjab & Sind Bank that will mature in tranches between 2030 to 2035. 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).
  • While this is a financial illusion, finally the government has realised that it is better to do what Western countries are doing rather than what their academicians are recommending us.