Zero-Coupon Bonds
Zero-Coupon Bonds
A zero-coupon bond pays no periodic interest. Instead, you buy it at a steep discount and receive par at maturity. The "interest" is the difference between your purchase price and par. Zero-coupon bonds are highly sensitive to interest-rate changes.
Key takeaways
- Zero-coupon bonds have no coupons; you buy at a discount (e.g., $400 per $1,000 face value) and receive $1,000 at maturity.
- The difference between purchase price and par is the "accretion" or imputed interest—your return.
- Zero-coupon bonds have very high duration (they're extremely sensitive to interest-rate changes) because all cash is received at the end.
- STRIPS (Separate Trading of Registered Interest and Principal) are Treasury zero-coupon bonds created by splitting conventional Treasuries into principal and interest pieces.
- Zero-coupon bonds create a "cliff" risk: no cash flow until maturity, and large price movements for small rate changes.
How zero-coupon bonds work
A standard bond paying 4% annually produces $40 per year. A zero-coupon bond produces nothing until maturity. To compensate you for this, a zero-coupon bond is sold at a deep discount.
Suppose a zero-coupon bond matures in 10 years and pays $1,000 at maturity. If the market yield is 4% per year, what's the fair price today?
Price = $1,000 / (1.04)^10 = $1,000 / 1.4802 = $676
An investor buys the bond for $676 and receives $1,000 in 10 years. The $324 difference is the return—earned entirely at maturity, not in periodic coupons. The annualized return is 4% (the yield that discounts $1,000 to $676).
If yields rise to 5%, the bond's price falls:
Price = $1,000 / (1.05)^10 = $1,000 / 1.6289 = $614
A 1 percentage point rate increase (from 4% to 5%) causes a $62 price decline (from $676 to $614), a loss of 9.2%. For a traditional 10-year bond with 4% coupons, the same 1% rate increase would cause a much smaller decline (around 8%).
This sensitivity is the defining characteristic of zero-coupon bonds: all your return comes at the end, so the present value of that distant $1,000 is extremely sensitive to discount rates.
Duration of zero-coupon bonds
The duration of a bond measures its sensitivity to interest-rate changes. For a traditional bond, duration is typically less than the bond's stated maturity (because you receive coupon payments before maturity, reducing the weighted-average time to cash receipt).
For a zero-coupon bond, duration equals its maturity. A 10-year zero-coupon bond has a duration of 10 years, making it extremely volatile. A 1% rate change causes roughly a 10% price change (using the duration approximation).
This extreme duration means zero-coupon bonds are bets on interest rates. If you buy a 10-year zero and rates fall, your return is exceptional. If rates rise, your loss is severe. For portfolio managers trying to manage risk, this volatility is either desirable (if they're betting on rates falling) or undesirable (if they want stable returns).
STRIPS and synthetic zeros
U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are created by investment banks that buy conventional Treasury bonds, split them into individual cash flows (each coupon payment and the final principal payment), and sell each piece as a separate zero-coupon bond.
For example, a 10-year Treasury note paying semi-annual coupons (20 coupon payments plus 1 principal payment) can be split into 21 separate zero-coupon bonds:
- One matures in 6 months (for the first coupon)
- One matures in 1 year (for the second coupon)
- ...
- One matures in 10 years (for the final coupon plus principal)
A Treasury STRIP maturing in 10 years behaves like a true zero-coupon bond: you buy at a deep discount and receive par at maturity. STRIPS are highly liquid and backed by the U.S. government, making them popular for institutional portfolios and immunization strategies.
Treasury STRIPS are available with maturities from 6 months to 30 years. They're commonly used by pension funds (which need to match long-dated liabilities) and in insurance company portfolios.
Accreted interest and taxes
For zero-coupon bonds, "interest" accretes over time even though you receive no cash. Each year, the IRS requires you to recognize this accreted interest as taxable income, even though you don't receive it until maturity.
Suppose you buy a zero-coupon bond for $400 with a $1,000 maturity in 10 years. The implied yield is approximately 9.6% per year. In year 1, your accretion is roughly $38 (assuming straight-line or constant-yield accrual). The IRS taxes you on that $38, even though you receive no cash that year.
This tax inefficiency makes zero-coupon bonds unattractive in taxable accounts. They're much more useful in tax-advantaged accounts (401(k), Roth IRA, traditional IRA) where accrued interest doesn't trigger annual tax bills.
Example: zero vs coupon bond comparison
Compare two bonds, each maturing in 10 years:
- Coupon Bond: 4% coupon, purchased at par (100). You receive $40 per year for 10 years, then $1,000 principal.
- Zero-Coupon Bond: Purchased at 67.6 (a price of 67.6% of par, or $676 per $1,000 face value). You receive $1,000 in 10 years.
Both have the same yield to maturity: 4%.
Rate rise to 5%:
- Coupon Bond: Price falls to ~92. Loss of ~8%.
- Zero-Coupon Bond: Price falls to ~61. Loss of ~10%.
Rate falls to 3%:
- Coupon Bond: Price rises to ~108. Gain of ~8%.
- Zero-Coupon Bond: Price rises to ~74. Gain of ~10%.
The zero-coupon bond magnifies both gains and losses because of its higher duration.
Corporate and other zero-coupon bonds
Beyond Treasury STRIPS, corporations occasionally issue zero-coupon bonds. These are less common because:
- Corporate creditors prefer regular cash payments (coupons), which reduce default risk from the issuer's perspective (the company needs cash to pay, forcing discipline).
- Corporate zeros magnify credit risk: if the issuer deteriorates, the price can collapse because there's no cushion of regular coupon payments to reassure investors.
- They're less liquid than Treasury zeros because the market for them is smaller.
Convertible bonds (bonds that can be converted into stock) are sometimes issued with zero or low coupons. The conversion feature compensates for the lack of coupon income.
Reinvestment considerations
A zero-coupon bond eliminates reinvestment risk in one sense: you receive no cash to reinvest until maturity. But you face maturity risk: when the bond matures, you must reinvest the $1,000 at prevailing rates. If rates have fallen, you're stuck reinvesting at low rates.
This is why zero-coupon bonds are useful for liability matching. If you know you'll need $1,000 in 10 years (to pay for a child's college, for example), buying a 10-year zero-coupon bond today locks in that future value, regardless of future interest rates.
Liquidity and spread
Treasury STRIPS are highly liquid; you can buy and sell them easily in the secondary market. Corporate zeros are less liquid. If you're forced to sell early and rates have risen, you could face a significant loss and wide bid-ask spreads.
Bid-ask spreads on Treasury STRIPS might be 2 to 5 basis points on large sizes. On corporate zeros, spreads might be 25 to 100 basis points, depending on size, issuer, and maturity.
Pricing mechanics: present value at work
Related concepts
Next
Zero-coupon bonds are one extreme: all cash at the end. The next bond type pushes to the opposite extreme: bonds with no maturity date at all. Let's explore perpetual bonds and consols—bonds that pay forever.