Zero Coupon Bond
A zero coupon bond is a fixed income security that pays no periodic interest (coupon) during its life and is instead issued at a deep discount to its face value, with the investor's return coming entirely from the appreciation toward face value at maturity. The difference between the purchase price and face value represents the investor's total return.
Key takeaways
- Zero coupon bonds eliminate reinvestment risk: since there are no interim coupon payments, the investor's realized yield exactly equals the YTM at purchase, assuming held to maturity.
- Zero coupon bonds have the highest duration of any bond with the same maturity: duration equals maturity since there are no intermediate cash flows.
- Despite receiving no cash interest, holders of taxable zero coupon bonds must typically pay annual taxes on the 'phantom income'—the accreted interest imputed each year.
- U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities) are zero coupon bonds created by stripping coupons from regular Treasury bonds.
- Zero coupon bonds are widely used for liability matching by pension funds and insurance companies, as they provide a certain lump sum at a known future date.
Explanation
Zero coupon bonds occupy a unique and important place in the fixed income landscape precisely because of what they lack: interim cash flows. This absence transforms the bond into a pure present value instrument, making its pricing and risk characteristics cleaner and more straightforward than coupon-bearing alternatives. The price of a zero coupon bond is simply the present value of its face value discounted at the yield: P = F / (1 + y)^n, where F is face value, y is the periodic yield, and n is the number of periods to maturity.
The duration of a zero coupon bond equals its maturity—the longest possible duration for any bond of a given term. Because all cash flows occur at the single terminal date, there is no intermediate cash flow to reduce the portfolio's sensitivity to interest rate changes. A 10-year zero coupon bond has a modified duration of approximately 10 years, meaning its price falls by approximately 10% for every 100-basis-point increase in yield. This extreme duration makes zero coupon bonds powerful instruments for interest rate speculation and for liability-driven investing (LDI) where long-dated liabilities must be matched with assets of equivalent duration.
U.S. Treasury STRIPS are the most prominent zero coupon instruments. Created since 1985 under the Treasury's STRIPS program, these are created by dealer banks who separate the coupon payments and the principal repayment of standard Treasury notes and bonds into individual zero coupon components. Each stripped coupon becomes a separate zero coupon bond maturing on its original payment date; the principal component matures at the bond's maturity. STRIPS trade actively in secondary markets and are particularly popular with pension funds and insurance companies seeking duration extension without credit risk.
The tax treatment of zero coupon bonds issued at original issue discount (OID) creates a significant cash flow challenge for taxable investors. Under U.S. tax law (IRS rules on OID), the annual accretion of a zero coupon bond's value is treated as taxable ordinary income each year, even though the investor receives no actual cash until maturity. This 'phantom income' creates a negative carry situation: the investor must pay taxes annually on income they have not yet received. As a result, OID zero coupon bonds are most tax-efficiently held in tax-deferred accounts (IRAs, 401(k)s) or by tax-exempt investors such as pension funds.
Formula
P = \frac{FV}{(1 + y/m)^{n \cdot m}}
Example
A pension fund needs to fund a $50 million liability that matures in exactly 20 years. To achieve a perfect asset-liability match, the fund purchases U.S. Treasury STRIPS maturing in 20 years. If the current 20-year spot rate is 4.50%, the price of each $1,000 face value STRIP is $1,000 / (1.0225)^40 = approximately $411.99 (using semi-annual compounding). To purchase $50 million face value of STRIPS, the fund pays $411.99 × 50,000 = approximately $20.6 million today. In 20 years, the STRIPS pay out exactly $50 million—perfectly matching the liability with no reinvestment risk, no coupon payment complexity, and no credit risk. The fund has immunized itself against interest rate risk completely: the duration of the STRIPS equals 20 years, precisely matching the liability duration.
Related terms
Basis Bond Bullet Bond Cdo Squared Corporate Bond Credit Risk Duration Face Value Interest Rate Modified Duration Negative Carry Present Value