Glossary term
Zero-Coupon Bond
A zero-coupon bond is a bond that pays no periodic interest and is instead bought at a discount and redeemed at face value at maturity.
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What Is a Zero-Coupon Bond?
A zero-coupon bond is a bond that does not pay periodic interest. Instead, the investor buys the bond at a discount to face value and receives the face value at maturity, assuming the issuer does not default and the bond is not redeemed earlier under its terms.
The return is built into the difference between the purchase price and the maturity value. A $1,000 zero-coupon bond bought for $700 does not send coupon checks. The investor's economic return comes from the bond accreting toward $1,000 over time.
Key Takeaways
- Zero-coupon bonds do not make regular coupon payments.
- They are issued or traded at a discount to face value.
- The investor's return comes from price accretion toward par at maturity.
- They can be highly sensitive to interest-rate changes, especially when maturities are long.
- Taxable investors may owe tax on imputed interest before receiving cash, depending on the bond type and account.
Price and Yield Formula
A simplified annual zero-coupon bond price is:
In this expression, y is the yield per period and n is the number of periods until maturity. The formula shows why price and yield move in opposite directions. If the required yield rises, the present value of the future face value falls.
For example, a zero-coupon bond that will pay $1,000 in 10 years is worth about $744 if the market yield is 3% annually. If the required yield rises to 5%, the present value falls to about $614.
Investor Tradeoffs
Zero-coupon bonds can be useful when a future cash need has a known date. A parent funding a future tuition payment or an institution matching a future liability may like the certainty of a single maturity payment, subject to credit risk. Treasury STRIPS are a common government-backed example of zero-coupon exposure.
The tradeoff is cash-flow timing. Because the bond pays nothing along the way, the investor cannot use coupon income for spending or reinvestment. Long-dated zero-coupon bonds can also be volatile because all of the cash flow is far in the future. That gives them high duration relative to many coupon bonds.
Tax and Call Issues
Tax treatment can surprise investors. Some zero-coupon bonds create taxable original issue discount income over time even though the investor receives no cash until maturity. Holding the bond in a tax-advantaged account can change the after-tax experience.
Callable zero-coupon bonds need special care. If an issuer can redeem the bond before maturity, the investor's expected accretion path may be interrupted. FINRA has highlighted that investors in callable zero-coupon bonds should understand both compound accreted value and the call price at the next call date.
The Bottom Line
A zero-coupon bond converts periodic interest into a discounted purchase price and a larger maturity payment. It can be a clean way to target a future cash value, but investors should understand duration risk, credit risk, taxes, liquidity, and call features before treating the maturity value as a simple sure thing.