Zero-coupon bond

Before you rely on it

What to check

In a taxable account, check the treatment of imputed interest.

The common error

Where people go wrong with zero-coupon bond

Overlooking the annual tax on interest never received. The bond pays nothing until maturity and can still create a tax liability every year along the way.

Worked through

Zero-coupon bond in plain numbers

A zero-coupon bond has a $1,000 face value and matures in ten years. If the market yield is 4%, its price is $1,000 ÷ 1.04¹⁰, about $675.56; it pays nothing along the way. The gain is the whole difference between the price and the face value, $324.44, earned as the bond ages toward maturity; a year later, at the same yield, the price is about $702.59. Because all the money arrives at the end, the price swings more than a coupon bond of the same maturity when yields change. A one-point rise in yield cuts this bond's price by about 9.6%. In many places the accrued interest is taxable each year even though no cash arrives.

Easily confused

Zero-coupon bond and its neighbours

A zero-coupon bond is not a discount bond in general, although it is priced at a discount. Any bond trading below face is a discount bond, but only a zero pays no coupon at all; it differs from a savings bond, which is a specific government product. Treasury STRIPS are zeros made by separating the coupons and principal of Treasuries. Its duration equals its maturity, higher than a coupon bond of the same maturity. Zero-coupon rates, or spot rates, are also the building blocks for pricing every other bond.

In real decisions

Where zero-coupon bond turns up

Investors use zeros to lock in a known future amount for a goal such as tuition or a retirement date. Pension funds match liabilities with them; planners build ladders from them. Traders use them for duration exposure. Financial models use zero rates for discounting. A calculator gives the price from face value, yield and time, or the yield from price.

Know the edges

Where zero-coupon bond stops being reliable

Price sensitivity is high, so a rise in rates can cause large losses if you sell before maturity. Credit risk remains, and inflation can erode the fixed final payment. Taxes on accrued interest may apply annually. Liquidity can be limited for some issues. Hold to maturity if you need the known amount, and check the issuer and tax treatment.

Quick answers

What people ask about zero-coupon bond

Why are zero-coupon bonds sold at a discount? Because they pay no interest along the way. The return comes from buying below face value and receiving face at maturity.

Are zero-coupon bonds riskier? Their prices react more strongly to interest-rate changes than coupon bonds of the same maturity. Credit risk depends on the issuer.

Are there tax issues? In many places, accrued interest is taxable each year even though no cash is received. Tax-advantaged accounts or tax-exempt issuers can avoid that. Check your rules.