A client needs Rs 20 lakh a year for the next five years. Using a zero-coupon yield curve, what does a bond ladder that meets the need cost today, and which risks does it remove?

The ladder costs about Rs 81.7 lakh today. Each year's Rs 20 lakh is bought with its own zero-coupon bond, priced at its own yield: Rs 18.73 lakh for year one down to Rs 14.06 lakh for year five. The ladder removes the need to sell anything at a bad price and fixes the reinvestment rate. It leaves inflation, early withdrawal and, off government paper, credit risk.

Because each payment is a different product with its own price. Think of booking five train tickets for five different dates: each fare is set for its own day, and the total is the sum of five fares, not one fare times five. A zero-coupon bondA bond that pays no interest along the way and returns one fixed amount at maturity; you buy it below that amount and the gap is your return. for year t costs the payment divided by (1 + y_t) to the power t, and the ladder is five such purchases. Using a single average yield of about 7.1% gets close here because the curve is fairly flat, but on a steep curve it misprices the far rungs.

Three, and it helps to name them in order. First, she never has to sell: each bond matures exactly when the money is needed, so a rise in yields cannot force a sale at a loss. Compare holding one five-year bond and selling a slice each year. If yields rose one point in year one, the bond with four years left would fall roughly 3.7% in price, about Rs 2.3 lakh on what is still invested, and she would sell into that loss. Second, the return is locked at purchase: with zero coupons there is nothing to reinvest, so a fall in rates cannot shrink the payments. Third, the payments do not depend on equity markets, so a crash in year two changes nothing about year two's Rs 20 lakh.

Inflation first. The ladder fixes rupees, not what the rupees buy: at 5% inflation, year five's Rs 20 lakh buys about what Rs 15.7 lakh buys today. If her daughter's fees rise with inflation, the later rungs need to be larger, or a small growth sleeve should sit alongside the ladder. Second, early withdrawal: if she needs money before a rung matures, that bond is sold at the market price of the day, which brings price risk back. Third, credit: on government paper it is negligible, but a ladder built from corporate bonds or deposits adds default risk to each rung, and a higher yield there is a payment for that risk, not free money.

Tax is a separate question worth raising, not settling on the spot. How the gain on a zero-coupon bond is taxed, and when, depends on the instrument and her circumstances; confirm the current treatment before comparing the ladder with, say, a deposit or a debt fund. A clean answer to the interviewer is the number, the three risks removed, the three left, and one sentence on tax to confirm.