I Hope you had read the previous parts of this series, if not, then click here read it. In the continuity of previous article, today we will discuss about the remaining types of bonds. Current article discusses about Zero Coupon Bonds, Junk Bonds and Tax Saving Bonds. So, here we start.
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The name itself describes what these bonds are. Yes, you got it right, these bonds do not provide benefits of coupon to its investors and no coupon is equal to no interest. These are generally issued for long term, at least 10 years.
Isn’t it sounding something illogical? Because if there will be no benefit then why will one invest in this?
A zero-coupon bond, also known as an ‘accrual bond,’ is a debt security that doesn’t pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value.
That means there will be profit on maturity. Secondly, zero coupon bonds are actually not a zero coupon as the companies take out their coupons but pay the together at maturity with principle amount.
But, there is one problem. If the coupons are paid at the end then that doesn’t mean that the income will also accrue at the end.
No. Not at all, the income will be accrued at the time which is mentioned in the coupon and accordingly, the investor have to pay tax on accrued interest income.
For Example: if the coupon states that interest will be credited on 10th july, 2020 but the company decided to pay the amount at maturity with the principle amount in june 2025, then in that case the income will be deemed to be accrue on account of interest income and therefore, the point of taxability will arise in the year 2020-21 itself.
The advantage of investing in these bonds is the fulfillment of long term goals which can be easily managed as the money will be received at some future date.
For example: one can invest in these securities for meeting out the future education expenses of his/her children.
For understanding of these bonds, you have to go through the following example:
Suppose there are 2 companies in the industry ABC Private Ltd. and XYZ Private Ltd.
They both have invited public to purchase their bonds but the track record of ABC ltd. Is far much better than XYZ ltd. in terms of their credibility of payment, previous records. So, after analyzing the conditions, maximum people will purchase the bonds of ABC ltd and due to this, the bonds of XYZ Ltd. will become low traded bonds in the market and that’s why they are termed as Junk Bonds.
Why to invest in Junk Bonds?
Junk bonds are risky investments, but they have speculative appeal because they offer much higher yields than bonds with higher credit ratings. Investors demand that junk bonds pay higher yields as compensation for the risk of investing in them. If a junk bond manages to turn its financial performance around and has its credit rating upgraded, the investor may see a substantial appreciation in the bond’s price.
Bonds are rated based on the revenue they generate to make principal and interest payments, and based on any assets pledged to secure the bond. The more revenue a bond can generate, the higher the credit rating.
Secured & Unsecured Junk Bonds:
A secured bond uses specific assets that serve as collateral, and in case of no profit, that asset can be sold to make principal or interest payments if any payments are missed.
Unsecured bonds, on the other hand, depends upon the payment capabilities of the issuer.
The credit rating is effected a lot by the payment capabilities and the types of assets charged for the payment.
Because junk bonds have a high default risk, they are speculative. Default risk is the chance that a company will be unable to pay its obligations when the bonds mature. Even when a junk bond defaults, it might still keep some of its value.
The name itself says, the bonds which provide the benefits to owner in respect of savings in tax are called Tax Free Bonds.
Section 80CCF of the Income Tax Act, 1961 states In computing the total income of an assessee, being an individual or a Hindu undivided family, there shall be deducted, the whole of the amount, to the extent such amount does not exceed twenty thousand rupees, paid or deposited, during the previous year relevant to the assessment year. So, in short one can reduce his income tax liability by investing in prescribed tax saving bonds to the extent of Rs. 20,000.
Don’t misinterpret the Tax Saving Bonds as Tax Free Bonds as they both are entirely different. Tax free bonds means Zero/Nil tax whereas Tax Saving Bonds helps in saving a little of our money to be paid as tax.
*These will be discussed in further parts of this series.
In this part we had discussed fully about the “Security” category of long term debt asset class which includes “Bonds”.
For more parts, stay tuned. Don’t forget to share this useful info with your friends.
In the next part we will discuss about the further categories of Long term debt asset class i.e.
So, don’t miss it.
Kindly Note: The author’s intention is only confined to create awareness about the stock market. Do not take anything as any investment advice as the author do not deals in investment advisory services.