Deep Discount bonds and Zero Coupon Bonds
In 1992 investors were drawn to exciting advertising by Industrial Development Bank of India (IDBI), a Central Government promoted Development Financial Institution, calling for subscription to its Flexi-Bonds. The terms were mouth-watering, offering bonds with a face value of Rs. 1 lakh for Rs. 2,700. The face value of Rs. 1 lakh on each bond would be paid to the investor in 25 years. No surprise that the bond issue received tremendous response.
Hitherto only institutional investors had access to such products through “Treasury Bills” or T-Bills issued by the Reserve Bank of India. T-Bills are issued with a face value of Rs. 1,000 each, at a lower price. The holder earns that difference in price till redemption at Rs. 1,000. Treasury bills were first issued in India in 1917. A regular auction of T-Bills was started by the RBI in 1987. The issues are in the nature of Deep Discount Bonds (DDB).
IDBI exercised its call in 2002, 10 years after the issue, and paid the investor Rs. 12,000 as advertised. (The investor earned just a little more than double every 5 years – a return of over 14% compounded annually. For easy measurement tools check out the 11th article in this series, “A measurement of returns”. The Rules of 72, 69, or 144 provide tip-of-the-finger comfort in working out the rate of doubling money).
Indian investors had been exposed to cumulative deposits till these issues. Cumulative deposits or bonds continue to be available and favored by investors seeking a lump sum (or bullet) repayment of their fixed-income investments. A cumulative product provides clarity of coupon paid. The taxation of the returns depends on the tax treatment prescribed at the time, varying from being taxed at maturity or on the accrued interest being taken up for tax in the year it is earned.
Another avatar of the deep discount bond is the zero-coupon bond (ZCB). They are often considered the same, but a distinction in some issues has the ZCB providing a redemption premium. The DDB is always redeemed at par value, while the ZCB may not be.