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Risk free Zero coupon bonds ('ZCB' or Zeros): How does it improve financial planning?

The fixed income instruments that meet the investment requirements will have one of the following
cash flow characteristics:
 Regular income cash flows that involves regular periodic incomes and a terminal payment of
principal initially paid. The fixed deposits of banks paying interest periodically, debentures and
bonds of financial institutions provide regular income in the form of coupon payments
periodically and repayment of principal at the end of the period.
 Annuity cash flows involve periodic payments on equated basis for an initial payment made.
Insurance companies and defined contribution pension schemes provide such cash flows on
the initial investments.
 Deep discount present value cash flows that provide a large single cash flow at a future date
for a small amount paid initially. Deep discount bonds are also known as zero coupon bonds.
Zeros are simple to compute as there is only one cash flow to be priced and helps better
financial planning.

Reserve Bank of India has issued guidelines for creating risk free zero coupon bonds (zeros) from the
existing coupon bearing government securities with interest payment date of 02/01 and 02/07. The
zeros may be created by stripping the coupons and principal by issuing securities for each coupon and
principal. For example, take the case of a security 6.35% GOI 2020. The security pays interest of 3.175
every six months for 10years and a principal repayment of Rs.100 in the year 2020. We can strip the
security as follows:
 20 zeros with maturity of six months, one year, 18 months ... up to 10 years with a face value
of 3.175 and multiples thereof
 one principal security of Rs. 100 with a maturity of 10 years.

Zeros can be created from different securities. A separate ISIN is created for each security created. The
coupons created are fungible and can be held under one interest date even if they are created from
different securities. The table indicates the amount to be paid now to obtain Rs.1000 for purchase of
Zeros. If you pay Rs. 71 today you will get Rs.1000 after thirty years for an interest rate of 9% per
annum. You may have to pay Rs. 415 today to get Rs.1000 after 10 years for the same interest rate.
Thus the zeros are simple to understand as there is a single cash flow for each tenor.

Zeros do not have reinvestment risk like the coupon bonds and once you are aware of the cash flow
requirement after a specific tenor you may allocate the amount by discounting the cash flow at the
appropriate rate. You can structure portfolios in such a manner that the principal of the portfolio is safe.
For example, if you are managing a portfolio or Rs. 1 million you may invest Rs.415000 in a ten year
zero so that you will get Rs. 1Million at the end of ten years Rs. 585000 may be invested in variable
income instruments like equity and derivatives to capture the higher returns for the higher risk.

The liquid funds and banks obtain money from the households and invest in government securities and
bonds and run reinvestment risk and asset liability mismatch. The insurance companies and pension
companies do not have securities to match the premium inflows and contributions of the household
investors. The investment in zeros by these institutions will lead to better matching of asset liability.
The STRIPS ( Separate Trading of Investment and Principal of securities) program announced by RBI
is a significant step to create many zero coupon securities ranging from one year to thirty years from
the existing securities. The zeros are risk free instruments as the original securities have been issued by
government of India. The households will have opportunity for investing in instruments with tenors up
to 30 years. The investments can be chosen to have cash flows on specific dates to meet large cash flow
requirements for marriage or education at a future date or in the form of annuity flows to meet cash
flow requirements like pension. Currently the banks fixed deposits provide investment opportunity for
five years and households may have opportunity to invest up to 30 years in zeros.

Anybody can buy a dated government security and submit it to primary dealers for creating zeros
through STRIPS. The eligible securities are those with coupon dates 02/01 and 02/07 and with an
outstanding amount of Rs.100 billion. The holders of zeros may submit the income as interest income
for assessment of tax if held till maturity and submit as capital gains if they have sold it before
maturity. The zeros will be an attractive proposition for foreign institutional investors as the interest
income of the coupon bonds and securities attract withholding tax on the interest income.

To summarize:
− RBI has issued guidelines for creating risk free zero coupon securities from the existing dated
government securities through STRIPS
− Zeros provide an opportunity to invest in tenor up to thirty years without re-investment risk
− Zeros can be invested to provide a large cash flow to meet specific requirement or a series of cash
flow to meet pension requirements
− Zeros can also be invested to provide protection of capital as a part of portfolio management
strategy.
− Zeros can be created by anybody by purchasing a dated security and submit them to primary
dealers.
year to Interest Rates
maturity 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00%
30 170 147 127 110 95 82 71
29 180 157 136 118 103 90 78
28 191 167 146 127 111 97 85
27 203 178 156 137 120 106 93
26 215 190 167 147 130 115 101
25 228 202 179 159 141 125 111
24 242 215 192 171 152 136 121
23 257 230 206 184 165 147 132
22 272 245 220 198 178 160 140
21 289 261 236 213 193 174 157
20 307 278 253 229 208 189 172
19 325 297 271 247 225 209 188
18 345 316 290 266 244 224 205
17 366 337 311 286 264 243 224
16 388 359 333 308 285 264 245
15 412 383 356 331 308 287 267
14 437 408 382 357 334 312 292
13 464 435 409 384 361 339 318
12 492 464 438 413 390 368 348
11 522 495 469 445 422 400 380
10 554 528 503 479 456 435 415
9 587 562 538 516 494 473 453
8 623 600 577 555 534 514 495
7 661 639 618 597 578 558 540
6 701 681 662 643 625 607 590
5 744 726 709 692 676 660 644
4 789 774 759 745 731 717 703
3 838 825 814 802 790 779 768
2 889 880 871 863 855 847 839
1 943 938 934 929 925 920 916
0 1000 1000 1000 1000 1000 1000 1000