Zero-Coupon Treasury Bonds: Benefits and Risks

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A zero-coupon Treasury pays no interest along the way. You buy it below face value and receive the full face amount when it matures. That one difference from regular Treasury notes and bonds, which pay a coupon every six months, explains most of the benefits and risks. You get a known payoff on a known date, backed by the U.S. government, with no coupons to reinvest. In exchange, the price swings much more when interest rates change, and in a taxable account you owe federal tax each year on income you haven’t received.

Treasury zeros vs. regular Treasuries

The U.S. Treasury sells three main types of marketable debt. Bills mature in a year or less, notes mature in 2 to 10 years, and bonds mature in 20 or 30 years. Notes and bonds carry a fixed coupon paid twice a year, plus the face value at maturity. The Treasury does not auction zero-coupon notes or bonds at all.

Bills are different. A T-bill has no coupon. It is sold at a discount and redeemed at face value, so it works like a short zero-coupon security. That is why brokerage statements and fund holdings lists show entries such as “United States Treasury Bills 0%.” The 0% is the coupon rate, not the return. The return comes from the discount.

When investors talk about “Treasury zeros,” they usually mean longer zero-coupon securities with maturities up to about 30 years. Those come from stripping.

Where Treasury zeros come from

A 30-year Treasury bond is really a bundle of 61 promised payments: 60 semiannual coupons and one principal repayment. Stripping separates these payments so each one trades as its own zero-coupon security. A coupon due in 2040 becomes a zero maturing in 2040. The principal becomes a separate zero maturing on the bond’s final date.

Before the Treasury formalized this, brokerage firms did it themselves. In the early 1980s they bought Treasury bonds, held them in trust and sold receipts on the separate payments. These products carried trademarked names such as Merrill Lynch’s TIGRs and Salomon Brothers’ CATS, and generic versions were known as Treasury receipts or T-receipts. They were zero-coupon instruments, but they were certificates on bonds held by a custodian rather than direct Treasury obligations.

In 1985 the Treasury launched the STRIPS program (Separate Trading of Registered Interest and Principal of Securities). Eligible notes and bonds can be split into their components within the Federal Reserve’s book-entry system. Each piece is then a direct obligation of the United States. Pieces from coupons are called coupon STRIPS, and the principal piece is called principal STRIPS. The process can also run in reverse: a dealer that gathers all the components can reconstitute the original security. STRIPS replaced the private receipt products, which is why the market for Treasury zeros today is a STRIPS market.

How the price of a Treasury zero works

A zero’s price is just the present value of its single payment. Using the semiannual compounding convention for Treasuries:

Price = Face value ÷ (1 + yield/2)^(2 × years to maturity)

Hypothetical example (rates chosen for illustration only): a zero with a $10,000 face value and 20 years to maturity, priced at a 4% yield, costs $10,000 ÷ 1.02^40, or about $4,529. If you hold it for 20 years, you receive $10,000, and your annualized return is 4%.

If yields move right after you buy, with 20 years still left:

• Yield rises to 5%: price = $10,000 ÷ 1.025^40 ≈ $3,724, a loss of about 17.8%.
• Yield falls to 3%: price = $10,000 ÷ 1.015^40 ≈ $5,513, a gain of about 21.7%.

A one-point move in yield changes the price by roughly 18% to 22%. The reason is duration. A coupon bond returns part of your money early through coupons, so its effective horizon is shorter than its maturity. A zero returns everything at the end, so its Macaulay duration equals its maturity. Its modified duration here is about 20 ÷ 1.02, or 19.6, so each one-point change in yield moves the price roughly 19.6% before convexity. A 20-year coupon bond would move noticeably less.

Benefits of zero-coupon Treasury bonds

A known payoff on a known date. If you hold to maturity, the amount and timing are fixed when you buy. The yield you lock in is the yield you earn, because there are no coupons to reinvest at whatever rates exist later.

U.S. government credit. Corporate zeros can go decades without paying anything, so you have to trust the issuer’s credit for the whole period. STRIPS are direct Treasury obligations, which removes the issuer credit question that dominates corporate and many municipal zeros.

No call risk on modern issues. Some corporate and municipal zeros can be redeemed early, which disrupts a plan built around a specific maturity. Treasury notes and bonds issued today are noncallable, so STRIPS created from them pay out on schedule.

A small outlay for a large future amount. Because of the discount, the upfront cost can be a fraction of face value, and the fraction shrinks as maturity lengthens. This makes it simple to target a future sum, such as tuition due in a specific year or a planned home down payment.

Strong behavior in rate-cutting periods. When the economy weakens, the Federal Reserve often cuts short-term rates, and long Treasury yields frequently fall too as investors seek safety. Corporate and emerging-market bonds can fall in those periods because default risk rises. Treasury zeros carry no default risk of that kind and have the longest duration, so they tend to gain the most. In 2008, the Vanguard Extended Duration Treasury ETF (EDV), which holds long STRIPS, rose about 70% as rates dropped during the financial crisis. Some stock investors hold a slice of long zeros as a hedge against a bear market, and traders who expect rates to fall use them as a direct, unleveraged way to express that view.

Risks of zero-coupon Treasury bonds

Interest rate risk. The price example above runs in both directions. Long Treasury zeros are the most aggressive bond position available without leverage or derivatives, with no coupon income to soften a drop. If you sell before maturity, you get that day’s market price, which can be well below what you paid.

Volatility without stock-like returns. On their own, long zeros can swing as much as or more than the stock market, while their long-run return is in line with long-term Treasuries. They earn their place mainly as a hedge or as a matched liability, not as a stand-alone growth asset.

No guaranteed hedge. Zeros help a stock portfolio only when stocks fall and yields fall together. When inflation pushes rates up, stocks and long bonds can drop at the same time, and the zero then adds to the loss instead of offsetting it.

Inflation risk. A fixed nominal payment decades away is exposed twice to inflation. Rising inflation usually brings higher rates, which cut the market price. It also erodes what the final payment will buy. A $10,000 payoff in 20 years may cover far less than it does today, depending on how prices move.

Trading costs. STRIPS trade over the counter through dealers rather than on an exchange. Depending on the broker and the size of the trade, the spread between bid and ask prices can take a visible bite out of returns, especially if you sell early.

How Treasury zeros are taxed

The IRS treats the discount on a zero as original issue discount (OID). Each year you hold the bond in a taxable account, you must report the portion of the discount that accrued that year as interest income, even though no cash arrives until maturity. This is often called phantom income. Your cost basis rises by the amount you report, so you aren’t taxed on the same accretion again at maturity.

Two points soften this. First, Treasury interest, including OID on STRIPS, is exempt from state and local income tax. Second, the phantom-income problem disappears in tax-deferred or tax-free accounts such as IRAs and 401(k)s, which is where many investors hold zeros. In a taxable account, you have to pay the annual tax from other cash.

T-bills are taxed more simply: the discount is treated as interest in the year the bill matures or is sold, and it is likewise exempt from state and local tax.

Ways to buy Treasury zeros

Treasury bills at auction. You can buy T-bills directly from the Treasury through TreasuryDirect or through a brokerage account at auction. They are the only zero-coupon Treasury securities the Treasury sells directly.

STRIPS through a broker. STRIPS are not auctioned. Financial institutions create them, and you buy them on the secondary market through a brokerage account, choosing the maturity date that fits your goal.

Zero-coupon Treasury ETFs. Funds such as EDV and the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ) hold baskets of long STRIPS and trade like stocks. They are convenient for hedging or rate bets. However, a fund that tracks a long-maturity index sells holdings as they shorten and buys longer ones, so it never matures. You get the rate sensitivity of long zeros, but not the fixed payoff on a fixed date. If the goal is a specific sum on a specific date, individual STRIPS fit. If the goal is portfolio exposure, the funds may be simpler.

Matching a zero to a goal

Using a Treasury zero for a future expense comes down to a few steps:

1. Fix the date and amount you need, for example the first tuition bill in a specific year.
2. Pick STRIPS maturing just before that date, so the cash is available in time.
3. Buy enough face value to cover the target. Price is the face value times the discount factor from the formula above, and your broker quotes it directly.
4. Decide on the account. In a taxable account, budget for yearly federal tax on the accretion. In a tax-advantaged account, that drops out.
5. Plan to hold to maturity. The fixed payoff is only fixed if you don’t sell along the way.

Zeros can also be layered as a ladder, with one maturity per year, to fund a stream of expenses such as several years of tuition or early retirement spending.

Zeros also have gift and estate uses. If you give a zero, the gift is valued at its current price, not its face value. That uses less of the annual gift tax exclusion than the amount the recipient eventually collects.

The Bottom Line

Treasury zeros suit investors who need a set sum on a set date, such as tuition or a home down payment, and those seeking a hedge for periods when stocks and yields fall together. Holding individual STRIPS to maturity, ideally in an IRA or 401(k), locks in the yield and avoids the annual tax on phantom income. Selling early exposes you to large price swings and dealer spreads.