Zero-Coupon Bond

August 31, 2024 Fixed Income

A zero-coupon bond makes no periodic coupon payments and is typically bought at a discount, with return realized through accretion toward maturity value.

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A zero-coupon bond is a bond that does not make periodic coupon payments. Instead, it is typically purchased below face value and pays face value at maturity if the issuer performs, so the investor’s return comes from the discount accreting toward the maturity payment.

Key Takeaways

Zero-coupon bonds concentrate cash flow at maturity rather than paying interest along the way.
They often have high interest-rate sensitivity because there are no interim coupons to return cash earlier.
Investors may owe tax on imputed or accrued interest before receiving cash, depending on jurisdiction and account type.
Treasury STRIPS are one major public-market example of zero-coupon securities created from eligible Treasury securities.

How Zero-Coupon Bonds Work

The simplified price of a zero-coupon bond is the present value of the maturity payment:

P = \frac{F}{(1+r)^n}

Where P is price, F is face value due at maturity, r is the discount rate per period, and n is the number of periods. The formula assumes payment occurs as expected and does not address taxes, default, liquidity, or call features.

Practical Example

Suppose a zero-coupon bond with $1,000 face value is bought for $620 and matures in 10 years. The investor receives no coupon payments during the 10 years. If the issuer pays as promised, the investor receives $1,000 at maturity. The return is the difference between purchase price and maturity value, adjusted for time, tax treatment, and risk.

Zero-Coupon Bond vs. Coupon Bond

Feature	Zero-Coupon Bond	Coupon Bond
Periodic interest	None	Scheduled coupon payments.
Cash-flow timing	One maturity payment	Coupons plus principal repayment.
Reinvestment risk	Lower for interim coupons because there are no coupons	Coupon payments must be reinvested.
Price sensitivity	Often higher for same maturity and credit quality	Usually lower because cash returns earlier.
Tax timing	May create imputed or phantom income	Often tied more directly to cash coupon income.

Why Zero-Coupon Bonds Matter

Zero-coupon bonds can help match a known future cash need because the maturity payment is concentrated on a specified date, subject to issuer performance. They are also useful in fixed-income analytics because they isolate discounting without interim coupon reinvestment.

The tradeoff is risk concentration. Long-maturity zeros can be very sensitive to yield changes. Corporate or municipal zero-coupon bonds also carry issuer credit and liquidity risk. This page is educational and is not investment, tax, or legal advice.

Common Mistakes

Assuming no coupon means no taxable income. Some zero-coupon bonds can create taxable imputed interest before cash is received.
Treating the maturity payment as guaranteed for non-Treasury issuers.
Ignoring duration and price volatility before maturity.
Comparing a zero-coupon bond with a coupon bond using face value alone.
Forgetting that liquidity can be limited in some zero-coupon issues.

Public Source Checks

Investor.gov zero-coupon bond glossary explains that zero-coupon bonds are bought at a deep discount and pay face value at maturity, with possible tax on imputed interest.
TreasuryDirect STRIPS explains that each separated STRIPS piece is a zero-coupon security with one payment at maturity.
FINRA zero-coupon bond overview provides investor-focused discussion of zero-coupon bond mechanics and risks.

Coupon Bond: A bond that pays periodic interest.
Discount Bond: A bond trading below face or par value.
Treasury STRIPS: U.S. Treasury zero-coupon securities created by separating principal and interest cash flows.
Deferred Interest Bond: A related structure that delays cash interest.
Present Value: The discounting concept used to price a future maturity payment.

FAQs

How does a zero-coupon bond make money?

The investor buys it below face value and, if the issuer pays as promised, receives face value at maturity. The difference is the economic return before taxes, inflation, and transaction costs.

Do zero-coupon bonds have reinvestment risk?

They avoid reinvestment risk on interim coupon payments because there are no coupons, but they still have maturity reinvestment risk and price risk before maturity.

Are zero-coupon bonds tax-free?

Not necessarily. Tax treatment depends on issuer, account type, jurisdiction, and instrument terms. Some investors may owe tax on imputed interest before receiving cash.

Revised on Sunday, June 21, 2026

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