What Is a Zero-Coupon Bond? Types, Pricing and Returns

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A zero-coupon bond is a debt security that pays no periodic interest. The investor buys it for less than its face (par) value and receives the full face value at maturity. The gap between the purchase price and the face value is the investor’s entire return. That return is still interest: it is paid in one lump at redemption rather than in coupons along the way. This is why zero-coupon bonds are also called accrual bonds or discount bonds.

How a Zero-Coupon Bond Works

A regular coupon bond pays interest semiannually or annually and returns the principal at maturity. A zero-coupon bond keeps only the final payment, so the buyer pays less up front.

The value of the bond climbs toward par as maturity approaches. This rising value is called the accreted value. On the maturity date, price and face value meet. If the bondholder sells before then, the price depends on current market rates, not on the original purchase yield.

The discount is set by two inputs: the required rate of return and the time to maturity. A higher rate means a deeper discount. A longer maturity also means a deeper discount, because the money compounds over more periods. Long zeros can therefore sell for a small fraction of their face value.

Types of Zero-Coupon Bonds

• Treasury STRIPS. Under the U.S. Treasury’s STRIPS program (Separate Trading of Registered Interest and Principal of Securities), each coupon and the principal of an eligible Treasury note or bond can be separated and traded as its own zero-coupon security.
• Treasury bills. T-bills mature in a year or less, pay no coupon, and are issued at a discount and redeemed at par, the same structure as a zero.
• Municipal zero-coupon bonds. State and local governments issue zeros. Interest on many municipal bonds is exempt from federal income tax, and sometimes from state tax for in-state buyers.
• Corporate zero-coupon bonds. Companies issue zeros to defer cash interest payments. The investor carries the company’s credit risk until the single payment date.
• Zero-coupon funds. Some funds and ETFs hold portfolios of Treasury STRIPS, giving exposure to zero-coupon prices without holding each bond to maturity.

Zero-Coupon Bond Formula

The price of a zero-coupon bond is the present value of its face value:

Price = M ÷ (1 + r)^n

• M = maturity (face) value
• r = required annual rate of return
• n = years until maturity

U.S. bond yields are often quoted on a semiannual basis. In that case, the formula becomes Price = M ÷ (1 + r/2)^(2n).

Zero-Coupon Bond Example

Hypothetical example, annual compounding. An investor wants a 6% annual return on a zero-coupon bond with a $25,000 face value and three years to maturity.

Price = 25,000 ÷ (1.06)^3 = 25,000 ÷ 1.191016 ≈ $20,991

The bond trades at about 84% of face value. At maturity the investor receives $25,000, a gain of $4,009. That gain is equivalent to 6% compounded annually for three years.

Hypothetical example, a longer bond. Take a $1,000 face value bond with 10 years to maturity:

The compounding convention changes the price even at the same quoted rate, and one extra percentage point of yield takes about $62 off a $1,000 bond.

Working Backward to the Yield

If you know the price, you can solve for the return you lock in by holding to maturity:

r = (M ÷ Price)^(1/n) − 1

Buying the 10-year bond above at $675.56 gives (1,000 ÷ 675.56)^(1/10) − 1 = 4%. For a zero-coupon bond, this figure is the bond’s yield to maturity. It also matches the bond’s compound annual growth rate from purchase to redemption, because no coupons need to be reinvested.

Interest Rate Sensitivity

A coupon bond returns part of its value early through coupons. A zero returns everything on the last day, so its price reacts more strongly to rate changes. Its Macaulay duration equals its maturity. A 10-year zero has a duration of 10 years, while a 10-year coupon bond’s duration is shorter.

Hypothetical comparison, annual compounding, $1,000 face value, rates rise from 4% to 5%:

• 2-year zero: $924.56 to $907.03, a drop of about 1.9%
• 10-year zero: $675.56 to $613.91, a drop of about 9.1%

The same rate move hits the longer bond nearly five times as hard. When rates fall, long zeros gain more than shorter bonds or coupon bonds. A holder who keeps the bond to maturity still receives the face value, so the price risk matters only if the bond is sold early.

How Zero-Coupon Bonds Are Taxed

In the U.S., the discount on most zero-coupon bonds is treated as original issue discount (OID). The holder must report a portion of it as interest income each year, even though no cash arrives until maturity. This is the “phantom interest” or imputed interest that investors refer to. The rules sit in the Internal Revenue Code (sections 1272 to 1275 cover OID and imputed interest).

The annual amount is calculated with a constant-yield method. Each year’s interest equals the bond’s yield multiplied by its accreted value at the start of that year, so taxable interest grows as the bond accretes.

Hypothetical example: The 10-year, $1,000 zero bought at $675.56 to yield 4% would accrue about $27.02 of interest in the first year. In the final year it would accrue about $38.46, as the value moves from roughly $961.54 to $1,000.

There are common ways to avoid paying tax on income you have not received:

• Hold zeros in a tax-advantaged account such as an IRA.
• Buy tax-exempt municipal zeros or other zeros whose interest has tax-exempt status.

State and local tax treatment varies by issuer and state. Interest on Treasury securities is exempt from state and local income tax.

Why Investors and Traders Use Zero-Coupon Bonds

Known payment on a known date. If held to maturity and the issuer pays, a zero delivers a fixed sum on a fixed date. This suits goals with a set deadline, such as tuition due in a given year or a retirement start date. Pension funds and insurers use zeros to match specific future liabilities.

No reinvestment risk. Coupon bond investors must reinvest each coupon at whatever rate is available. A zero has nothing to reinvest, so its yield at purchase is its return to maturity.

Rate exposure for traders. Long-dated zeros carry the most duration per dollar invested among bonds of similar quality. Traders who expect rates to fall get the largest price response for their capital, and accept the largest losses if rates rise.

Limitations of a Zero-Coupon Bond

• Price volatility. Selling after rates have risen can produce a loss, and the loss grows with maturity.
• Inflation risk. The payout is fixed in nominal dollars. Over 20 or 30 years, inflation can sharply reduce what that sum buys.
• Concentrated credit risk. With a corporate or municipal zero, the entire return depends on one final payment. If the issuer defaults, there are no earlier coupons to soften the loss.
• Call features. Some zeros can be redeemed early by the issuer. Check the terms before buying.

Zero-Coupon Bonds vs. Related Terms

Discount bond vs. zero-coupon bond. Every zero is issued at a discount. However, a coupon bond can also trade below par when market rates rise above its coupon rate.

Does a zero always sell below par? When yields are positive, yes. Its price equals face value only at maturity, or if the required rate is exactly zero. Where government yields have turned negative, zero-coupon debt has priced above par, which locks in a loss for anyone holding to maturity.

The Bottom Line

Zero-coupon bonds suit investors who need a fixed sum on a set date, such as for tuition or retirement, and who plan to hold to maturity. Their prices swing more with rates than coupon bonds do, so selling early carries real risk. Taxable holders in the U.S. owe tax on accrued interest each year, which makes IRAs or tax-exempt municipal zeros the practical choice for many.