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A Zero Coupon Bond is a type of debt instrument that carries no coupon value, and is sold at a discount to its face value. For example, a zero-coupon bond with face value 10 maturing in 2025 trading at Rs 7 now, would give a return of 3 on maturity. In ZCBs, the return is known at the time of investment i.e there is no reinvestment risk. The Zero Coupon Yield Curve (ZCYC), which represents the yields or interest rates for a number of terms is derived from the yields of fixed rate bonds. A coupon bearing bond can be stripped down to a portfolio of ZCBs. In India, STRIPS are used and provide liquidity for government securities in the secondary market.
Discount Rate under IND AS 19
Under IND AS 19 actuarial valuation for employment benefit schemes, employers are required to account for their Post Employment Benefit Obligation plans in their annual statements. In the complex calculations, prescribed by IND AS 19, they are required to discount their future liabilities with reference to market yields at the end of the reporting period on government bonds. This brings the concept of yield curve on government bonds. Furthermore, IND AS 19 simplifies the calculation to an extent that instead of using the full yield curve, IND AS 19 allows the single weighted average discount rate, with the term of the government bonds being used consistent with the estimated term of the post-employment benefit obligations.
The spot zero coupon yield on a bond is the time weighted rate of return on a bond. This Zero Coupon Yield Curve provides the discounting factors for valuing liabilities and cash flows based on the maturity depicting the relationship between the interest rate and the term to maturity, whereas YTM curve discounts all cashflows by the same yield to maturity. Looking at other accounting standards that are used globally, paragraph 106 of FAS 106 specifically states that Zero Coupon yields must be used for valuation of post retirement benefits other than pensions.