What Is a Zero-Coupon Bond?
A zero-coupon bond skips periodic interest entirely. The investor buys it at a discount to face value and receives the full face amount at maturity, with the difference representing the return. A zero maturing in 10 years at a 5% yield would cost about $614 per $1,000 of face value, since $614 compounded at 5% annually grows back to $1,000.
Common examples include Treasury bills, which are short-term zeros by construction, and Treasury STRIPS, created when dealers separate the coupons and principal of a standard Treasury bond into individually traded pieces. Corporations and municipalities also issue zeros, often to defer cash outflows during long construction or growth phases.
How Pricing and Taxes Work
Price equals face value divided by (1 + yield) raised to the number of years to maturity. Because all cash arrives at the end, a zero's duration equals its maturity, making it the most rate-sensitive bond for any given term. A 30-year zero can lose roughly a quarter of its value from a one-percentage-point rise in yields, which also makes zeros powerful tools for expressing interest rate views.
Taxes are the catch. The IRS treats the annual accretion as original issue discount and taxes it as ordinary income each year, even though the investor receives nothing until maturity. This phantom income is why taxable zeros are usually held in tax-advantaged accounts such as IRAs, while municipal zeros avoid the problem because their imputed interest is federally tax-exempt.
Why It Matters
Zeros are ideal for matching a known future liability. A pension fund that owes $100 million in 2040 can buy zeros maturing that year and lock in the outcome regardless of where rates move, a strategy called immunization. Parents saving for a fixed tuition date and insurers matching future payouts apply the same logic on different scales.
In interviews, zeros anchor bond math questions because their pricing is a single discounting exercise with a clean answer. They also underlie the zero-coupon yield curve, the set of spot rates that traders bootstrap from market prices and use to discount every fixed income cash flow, so the concept extends far beyond the bonds themselves.
