Zero Coupon Bond
A zero coupon bond is a debt security that pays no periodic interest but is sold at a deep discount to face value, with the full face value paid at maturity—the return is the difference between purchase price and par.
Exam Tip
Zero coupon = no periodic interest, sold at discount. HIGHEST interest rate risk. Phantom income taxed annually. Duration = maturity.
What is a Zero Coupon Bond?
A zero coupon bond (also called a "zero" or "discount bond") doesn't pay periodic interest. Instead, it's purchased at a significant discount to its face value, and the investor receives the full face value at maturity. The return comes entirely from this price appreciation.
How Zero Coupon Bonds Work
| Feature | Description |
|---|---|
| Purchase Price | Deep discount to par |
| Coupon Payments | None ($0) |
| Maturity Payment | Full face value |
| Return | Difference between price and par |
Example
| Detail | Amount |
|---|---|
| Face Value | $1,000 |
| Purchase Price | $500 |
| Years to Maturity | 10 |
| Total Return | $500 (100% gain) |
| Approximate Annual Return | ~7.2% |
Types of Zero Coupon Bonds
| Type | Issuer | Features |
|---|---|---|
| Treasury STRIPS | U.S. Government | Safest, state/local tax exempt on interest |
| Corporate Zeros | Corporations | Higher yields, more risk |
| Municipal Zeros | Local governments | May be tax-free |
| Zero Coupon CDs | Banks | FDIC insured |
STRIPS (Separate Trading of Registered Interest and Principal Securities)
Treasury STRIPS are created by "stripping" regular Treasury bonds:
- Each coupon payment becomes a separate zero
- The principal becomes a separate zero
- All backed by U.S. government
Phantom Income Tax Issue
Important Tax Consideration:
- IRS requires annual taxation of "imputed interest"
- You pay taxes on interest you haven't received yet
- Called "original issue discount" (OID)
- Must report accrued interest each year
| Year | Accrued Value | Taxable Phantom Income |
|---|---|---|
| 1 | $535 | $35 |
| 2 | $572 | $37 |
| 3 | $612 | $40 |
| ... | ... | ... |
Best Uses for Zero Coupon Bonds
| Use Case | Why It Works |
|---|---|
| Tax-Advantaged Accounts | No phantom income issue (IRA, 401k) |
| Target Date Goals | Know exact value at maturity |
| Education Savings | Match bonds to college start dates |
| Retirement Planning | Predictable future income |
Zero Coupon Bond Risks
| Risk | Description |
|---|---|
| Interest Rate Risk | Highest of any bond (no reinvestment cushion) |
| Duration | Duration equals maturity (maximum sensitivity) |
| Liquidity Risk | Less liquid than coupon bonds |
| Phantom Income | Must pay taxes on unreceived income |
Interest Rate Sensitivity
Zero coupon bonds are the MOST sensitive to interest rate changes:
- No coupon payments to reinvest at new rates
- All return depends on final maturity payment
- Price swings more dramatically than coupon bonds
| Interest Rates Rise | Effect on Zero |
|---|---|
| 1% increase | Price drops significantly |
| More years to maturity | Greater price drop |
Zero vs. Coupon Bond Comparison
| Feature | Zero Coupon | Regular Bond |
|---|---|---|
| Periodic Income | None | Semi-annual |
| Reinvestment Risk | None | Yes |
| Interest Rate Risk | Highest | Lower |
| Price Volatility | Highest | Lower |
| Tax Complexity | OID rules | Simpler |
Study This Term In
Related Terms
Bond
SecuritiesA bond is a fixed-income debt security where the issuer owes the holder a debt and pays interest (coupon) plus principal at maturity.
Treasury Securities
SecuritiesTreasury securities are debt instruments issued by the U.S. government to finance operations, considered the safest investments due to being backed by the full faith and credit of the U.S.
Duration
SecuritiesDuration is a measure of a bond's price sensitivity to interest rate changes, expressed in years. A higher duration means greater price volatility when interest rates change.
Yield to Maturity (YTM)
SecuritiesYield to maturity is the total return anticipated on a bond if held until it matures, accounting for all coupon payments, the difference between purchase price and par value, and the time value of money.