Zero-coupon bonds struggle to retain investor demand amid mkt trend shifts

Zero-coupon bonds (ZCBs), also known as deep-discount bonds that do not guarantee periodic interest payment, are struggling to retain the investor demand seen in the second half last year. 

Monetary-policy easing, an abundant liquidity infusion, and a cut in the cash reserve ratio (CRR) cut by the Reserve Bank of India (RBI) in the recent monetary policy review weighed on bond yields, particularly those of short-duration bonds. 

The yield spread between the three-year government bond and the benchmark 10-year bond has increased more than four-fold to 61 basis points (bps), as against 15 bps at the start of the financial year. This has reduced the appeal of longer-term ZCBs, which were priced aggressively last year. In the secondary market, these bonds are trading at higher yields, causing mark-to-market losses and poor exit options for early investors due to thin liquidity. 

A zero-coupon bond is issued at a deep discount and redeemed at its full face value upon maturity, with the profit being the difference between the purchase price and the maturity value. In the recent issue by Power Finance Corporation (PFC), there was strong demand for the shorter-tenure (25-month) bond at a 6.27 per cent yield, but there was far less interest in five-year paper at 6.59 per cent, due to the wide spread. 

Similarly, its 10-year zero-coupon bond received negligible demand, and hence it was withdrawn. “ZCBs with CBDT (Central Board of Direct Taxes) approval have struggled to gain momentum this financial year. Recent issuances were withdrawn due to a subdued investor interest and yield expectations that exceeded what issuers were willing to offer,” said Venkatakrishnan Srinivasan, founder and managing partner, Rockfort Fincap LLP, adding that this short-term pause did not diminish the structural potential of ZCBs — especially in the current interest rate environment — if investors price them correctly. 

“While concerns about potential changes in capital gains tax treatment or limited secondary market liquidity exist, these are not unique to ZCBs and are common across all long-duration fixed-income products,” he said, adding that if issuers were willing to price ZCBs in line with prevailing market conditions, and if investors valued them appropriately, these instruments could offer a compelling mix of quality, tax efficiency, and certainty in a declining rate regime. 

Banks are not allowed to invest in ZCBs. They can put in money only if the issuing company sets aside a reserve for redeeming those bonds, a requirement that most companies do not fulfil. As a result, a major class of investors is absent from the market. While insurance companies do participate, demand remains subdued. “After the recent rate cut, long-term rates haven’t declined significantly, and since ZCBs are typically long-duration instruments, investors are waiting for more stability in the yield curve,” said a market participant. “This will continue unless the market settles down and the gap between three-year paper and a 10-year paper comes down,” he added. 

The initial excitement about ZCBs was sparked by REC’s issue last year. It saw robust participation. Buoyed up by this success, several infrastructure public-sector companies — including PFC, Housing and Urban Development Corporation (Hudco), and Indian Railway Finance Corporation (IRFC) — followed suit. Backed by AAA ratings and perceived sovereign support, these issuers positioned ZCBs as safe, long-term instruments offering predictable post-tax returns and minimal credit risk. High-net-worth individuals (HNIs) and family offices, in particular, were drawn to the product’s tax-efficient lump-sum payout structure.