Zero-Coupon Bond

A zero-coupon bond ("zero") pays no periodic interest. Instead it is issued, or trades, at a discount to its face value and repays the full face amount at maturity. The entire return is the gap between purchase price and repayment: pay $600 today for $1,000 in twelve years and the 67% total gain is your interest, arriving all at once at the end.

Key takeaways

Zeros pay nothing until maturity; the discount is the return.
Treasury bills are short-term zeros by construction; STRIPS are long-term Treasuries split into zero-coupon pieces.
Because all cash arrives at the end, zero prices react more strongly to interest-rate changes than coupon bonds of the same maturity.
In several tax systems the accruing discount is taxed yearly as "phantom income" even though no cash is received.

How the pricing works

The price of a zero is the face value discounted at the prevailing yield for its maturity: price = face ÷ (1 + yield)^years. The mathematics is compound interest run backwards. This makes zeros the cleanest illustration of the time value of money, and they are used to build the theoretical "zero curve" that underlies professional bond pricing.

Duration: why zeros swing harder

A coupon bond returns money along the way, softening the impact of rate changes. A zero returns everything at maturity, so its sensitivity to rates (duration) equals its full remaining life. A 25-year zero can lose or gain a fifth of its value on a two-percentage-point rate move, behaviour that surprises buyers who equate "government bond" with "stable price". The credit may be safe while the price is volatile; see Treasury securities for the distinction.

Where zeros come from

Governments issue bills as zeros directly. Long zeros mostly arise through STRIPS (Separate Trading of Registered Interest and Principal of Securities): dealers split a normal Treasury into its individual payments and sell each as a stand-alone zero. Corporations and municipalities also issue zeros, adding credit risk to the rate sensitivity.

Frequently asked questions

Why would anyone want a bond that pays nothing for years?

Descriptively, zeros match future liabilities precisely (a known payment due in exactly n years), avoid reinvestment risk on coupons, and offer the most rate sensitivity per dollar for those who want it.

What is phantom income?

Tax charged on the discount as it accrues each year, despite no cash arriving until maturity. U.S. taxable accounts face this on most zeros, one reason they are often held in tax-deferred accounts. Rules vary by country and are a matter for a tax adviser.