Zero-Coupon Bond
A zero-coupon bond is a debt security that pays no periodic interest but is issued at a deep discount to its face value and redeems at par at maturity, with the investor's return being the difference between the purchase price and the face value.
Zero-coupon bonds strip away the complexity of reinvesting periodic coupon payments. Instead of receiving semi-annual interest, the investor buys the bond at a fraction of its face value and receives the full face value at maturity. The difference — the discount — represents the investor's total return. A zero-coupon Treasury bond (commonly called a STRIP) that matures in 20 years might be purchased for roughly $370 per $1,000 face value if long-term yields are around 5%, with the investor's return entirely composed of that $630 appreciation over 20 years.
U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities) are the dominant zero-coupon instruments in the U.S. market. Created in 1985, STRIPS are not issued directly by the Treasury but are derived from standard Treasury notes and bonds. Financial institutions 'strip' the coupons from a Treasury bond and sell each cash flow as a separate zero-coupon security. An investor who buys a 20-year Treasury note's principal payment is effectively buying a 20-year zero-coupon bond backed by the full faith and credit of the United States.
Zero-coupon bonds have the longest duration of any fixed income security relative to their maturity. Because all value is concentrated in the single terminal payment, there are no interim cash flows to reduce the weighted average time to receipt. A 30-year zero-coupon bond has a duration of 30 years — meaning its price will fall roughly 30% if yields rise by 1 percentage point. This extreme interest rate sensitivity makes zeros powerful tools for duration management but also exposes investors to substantial market value risk.
The phantom income problem is a critical consideration for taxable accounts. Even though zero-coupon bonds pay no cash interest, the IRS requires the annual accretion of the discount to be recognized as ordinary income each year. A zero purchased at $500 that accetes to $550 over the first year generates $50 of taxable income even though no cash was received. For this reason, zero-coupon bonds are overwhelmingly held in tax-deferred or tax-exempt accounts — IRAs, 401(k)s, and education savings accounts — where the phantom income problem does not apply.
Series EE savings bonds issued by the U.S. Treasury are a familiar example of zero-coupon bonds accessible to retail investors. Issued at face value but earning interest that accrues over time (with a guaranteed doubling in 20 years if held that long), they function economically as zeros and are particularly popular as gifts for children or as conservative savings vehicles.