Zero-Coupon Bond: Definition, How It Works & Pricing
How Zero-Coupon Bonds Work
With a standard bond, you get two income streams: regular coupon payments plus the return of principal at maturity. A zero-coupon bond strips away the first part entirely. There are no semiannual checks, no interest deposits. You buy the bond cheap, wait, and collect the full face value when it matures.
The concept is simple. You pay $600 today for a bond with a $1,000 face value that matures in 10 years. At maturity, you receive $1,000. Your $400 gain — the spread between what you paid and what you received — is your return. No cash flow in between.
This structure makes zero-coupon bonds uniquely suited for situations where you need a specific dollar amount on a specific future date: funding a child’s college tuition, matching a known future liability, or locking in a guaranteed lump sum for retirement.
Zero-Coupon Bond Pricing
The price of a zero-coupon bond is simply the present value of its face value, discounted at the prevailing interest rate (or the bond’s yield to maturity):
Where r = yield per period and n = number of compounding periods to maturity.
Example Calculation
A zero-coupon Treasury bond has 15 years to maturity, a $1,000 face value, and a YTM of 4.5% (compounded semiannually).
Number of periods: 15 × 2 = 30
Price = $1,000 ÷ (1.0225)³⁰
Price = $1,000 ÷ 1.9525 = $512.16
You’d pay roughly $512 today and receive $1,000 in 15 years. That $488 gain reflects a 4.5% annualized return — with zero reinvestment risk, because there are no coupons to reinvest.
Common Types of Zero-Coupon Bonds
| Type | Issuer | Details |
|---|---|---|
| Treasury Bills (T-Bills) | U.S. government | Short-term (4 weeks to 1 year); the most common zero-coupon instrument in the market |
| STRIPS | U.S. Treasury (separated) | Created by separating a Treasury bond’s coupon and principal into individual zero-coupon securities |
| Corporate zeros | Corporations | Less common; typically issued by investment-grade companies; carry credit risk |
| Municipal zeros | State/local governments | Interest may be tax-exempt; popular for education savings and long-term planning |
| U.S. Savings Bonds (Series EE) | U.S. government | Technically zero-coupon; accrue interest and are redeemed at accumulated value |
Why Zero-Coupon Bonds Are More Volatile
Zero-coupon bonds are the most interest-rate-sensitive bonds in the market for their maturity. Here’s why.
With a regular bond, you receive cash flows throughout the bond’s life — each coupon payment shortens the effective time you’re waiting for your money back. This is measured by duration. A coupon-paying bond’s duration is always shorter than its maturity because those interim cash flows pull the average wait time closer to the present.
A zero-coupon bond has no interim cash flows. Its duration equals its maturity. A 20-year zero-coupon bond has a duration of 20 years — making it far more sensitive to rate changes than a 20-year bond paying a 5% coupon (which might have a duration of around 13 years).
| Bond Type (20-Year Maturity) | Approximate Duration | Price Change if Rates Rise 1% |
|---|---|---|
| 5% Coupon Bond | ~13 years | ≈ −13% |
| Zero-Coupon Bond | 20 years | ≈ −20% |
This cuts both ways. If rates fall, zero-coupon bonds rally harder than any other fixed-income instrument with the same maturity. That’s what makes them powerful — and risky — for investors who have a view on the direction of interest rates.
For more on how duration and rate sensitivity work, see Bond Duration and Convexity.
The Reinvestment Advantage
One underappreciated benefit of zero-coupon bonds: they eliminate reinvestment risk entirely.
When you own a coupon-paying bond, the YTM calculation assumes you reinvest each coupon at the same rate. In practice, rates change, and you might reinvest at a lower rate — dragging your actual return below the quoted YTM.
Zero-coupon bonds sidestep this problem. There’s nothing to reinvest. The return is locked in at purchase. If you buy a zero at a 4.5% yield and hold to maturity, you earn 4.5% — period. This makes zeros the purest way to lock in a guaranteed rate of return over a specific time horizon.
Tax Treatment — The Phantom Income Problem
Here’s how it works. The IRS requires you to impute interest annually using the original issue discount (OID) rules. Each year, a portion of the discount is treated as interest income and taxed at your ordinary income rate — even though no cash changes hands until maturity.
For this reason, zero-coupon bonds are best held in tax-advantaged accounts like a 401(k) or Roth IRA, where the phantom income doesn’t trigger a current tax bill. Tax-exempt municipal zero-coupon bonds are the other workaround — their imputed interest is generally exempt from federal income tax.
Who Uses Zero-Coupon Bonds?
Liability matchers. Pension funds and insurance companies use zeros to match known future obligations with precision. If you owe $10 million in 15 years, buying $10 million face value of 15-year zeros locks in the payout exactly.
College savers. Parents buying zero-coupon munis know exactly what they’ll have when tuition bills arrive — with potential tax benefits.
Rate speculators. Because of their extreme duration, zero-coupon bonds are the highest-leverage play on falling interest rates within the bond market. Traders who expect a rate cut buy long-dated zeros for maximum price appreciation.
Retirement planners. Zeros in a Roth IRA can grow tax-free from a low purchase price to full face value, making them a tax-efficient tool for long-horizon investors.
Key Takeaways
- Zero-coupon bonds pay no interest — they’re bought at a discount and redeemed at full face value at maturity.
- The price equals the present value of the face value, discounted at the prevailing yield.
- Duration equals maturity, making zeros the most rate-sensitive bonds — they gain or lose more than coupon bonds when rates change.
- Zeros eliminate reinvestment risk entirely, locking in a guaranteed return if held to maturity.
- The IRS taxes the annual accretion as phantom income, so zeros are best held in tax-advantaged accounts or as tax-exempt munis.
Frequently Asked Questions
How does a zero-coupon bond make money?
Your return is the difference between the discounted purchase price and the face value received at maturity. If you buy a bond for $700 and receive $1,000 at maturity, your profit is $300. The yield to maturity expresses this as an annualized percentage return.
Are Treasury bills zero-coupon bonds?
Yes. T-bills are short-term zero-coupon securities issued by the U.S. government. They’re sold at a discount to face value with maturities ranging from 4 weeks to 52 weeks. At maturity, the government pays you the full face value.
Why are zero-coupon bonds more volatile than regular bonds?
Because their duration equals their maturity. Regular bonds have interim coupon payments that reduce effective duration. Without those cash flows, zeros have maximum sensitivity to interest rate changes. A 1% rate increase causes a much larger price drop on a 20-year zero than on a 20-year coupon bond.
Do I have to pay taxes on a zero-coupon bond every year?
In a taxable account, yes. The IRS requires you to report imputed interest (phantom income) annually under the original issue discount rules, even though you don’t receive any cash until maturity. Holding zeros in a Roth IRA, 401(k), or buying tax-exempt municipal zeros avoids this issue.
What is a STRIPS bond?
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. Dealers take a regular coupon-paying Treasury bond and “strip” it into separate zero-coupon components — each individual coupon payment and the final principal payment become standalone zero-coupon securities. They trade separately in the secondary market and are backed by the full faith and credit of the U.S. government.
Can I sell a zero-coupon bond before maturity?
Yes, you can sell in the secondary market at any time. But the price you receive will depend on current interest rates. If rates have risen since you bought, the price will be lower. If rates have fallen, the price will be higher. Because of their high duration, the price swings can be substantial — especially for long-dated zeros.