Zero coupon bonds are back in flavour. Will the party continue? 

A clutch of non-banking financial companies (NBFCs) have issued zero coupon bonds to meet their funding requirements. The trend is expected to continue after recent interest rate increases as companies look to preserve their cash flows, money market experts said.

Zero coupon bonds do not pay interest during the tenure of the security. They are issued at a discount to the face value of the bond. The subscriber or investor receives the face value of the investment on maturity. The difference between the issue price and the maturity value of the zero coupon bond is the capital gain for the investor.

In August, NBFCs such as TMF Holdings, Tata Motors Finance, Tata Capital Financial Services and L&T Finance raised an aggregate Rs 1,683 crore via zero-coupon bonds maturing in two years to four years.

The yield on these bonds ranged from 7.21 percent to 8.50 percent. Continuing the trend, ICICI Home Finance, on September 2, raised Rs 125 crore via two-year zero-coupon bonds at a yield of 7.24 percent.

“Big, reputed corporates are now frequently issuing zero coupon bonds,” said Venkatakrishnan Srinivasan, founder and managing partner at Rockfort Fincap, a Mumbai-based debt advisory firm.

“It is good to see this structure is back and getting accepted by investors again,” added Srinivasan. “Major issuances are currently from highly-rated entities like from the Tata Group, which can be seen as a confidence-building measure.”

Zero coupon bonds are typically issued when the interest rates in the economy are high. These securities help in providing liquidity to bond issuers as they do not have to pay interest and principal until maturity. This helps them preserve their cash.

In the current environment, bank lending rates have started rising, while corporate bond rates are also inching higher, making fund raising expensive. Since a large proportion of bank loans are linked to the external benchmark lending rate, or the repo rate, the re-pricing of bank loans has been quick and steep due to consecutive rate hikes by the Reserve Bank of India (RBI). This has brought back zero coupon bonds back in flavour.

The Monetary Policy Committee (MPC) has raised the repo rate by 140 basis points since May to 5.4 percent to tame inflation. One basis point is one-hundredth of a percentage point.

“Zero coupon bonds are highly beneficial when the interest rates are high and there is no re-investment risk during the life period of the bond for the investors,” said Srinivasan of Rockfort Fincap. “Moreover, issuers with AAA rating have started issuing short tenor zero coupon bonds frequently. This also involves relatively lesser risk for investors.”

According to Sandeep Bagla, chief executive officer at TRUST Mutual Fund, another reason why zero coupon bonds are hitting the market could be because a set of investors find them attractive as they feel that these securities are more suitable for cash flow or tax planning.

Money market experts said the trend could continue in the long run as credit growth in the economy picks up and interest rates tighten further. They could also be issued by infrastructure companies, they said.

“Zero coupon bonds are mostly issued by infrastructure companies as the cash flow is not regular and the projects have a long gestation period,” said Umesh Kumar Tulsyan, managing director at Sovereign Global Markets. “For such companies these zero-coupon bonds will help them raise long-term funds, without regular interest payment. Hence, we may see lot of infra projects or infra companies coming up with zero coupon bonds.”

TRUST Mutual Fund’s Bagla also said that the trend will continue. However, the amount raised through zero coupon bonds is likely to be small relative to the overall corporate fund raising, he said. Most large-ticket fixed income investors are still risk averse, he added.

Moreover, the issuances lined up in the coming days could only be in the shorter tenure rather than for a long term to tap investor demand, said experts.

“Since zero-coupon bonds have lengthy maturity periods, it can be challenging for investors to continue their trust in the issuer till the maturity date arrives,” said Archita Joshi, a fixed income advisor at Motilal Oswal. “Another challenge could be liquidity of the bond,” added Joshi.​