What is a zero-coupon bond?
A zero-coupon bond is a debt security that pays no periodic interest. Instead, you buy it at a discount and get one payment at maturity. That payment equals the bond's face value, also called par value.
Think of it like a gift card you buy for less than it is worth. You pay $800 today and get $1,000 in ten years.
How it works
- Issuer sells the bond at a price below face value.
- No coupon payments go to the investor while the bond is outstanding.
- At maturity you receive one payment: the face value.
Issuers can be governments, corporations, or municipalities. Governments sometimes sell their own zeros. Treasury bills are a type of zero for short terms. STRIPS are government securities stripped into pure zeros.
Price formula
The basic price formula is:
Price = Face Value / (1 + r)^n
Where:
- Face Value is the amount paid at maturity, typically $1,000.
- r is the annual yield or discount rate as a decimal.
- n is the number of years until maturity.
Example: Face Value = $1,000 Yield = 4% or 0.04 Maturity = 5 years
Price = 1000 / (1.04)^5 ≈ 821.93
You paid 821.93 now to get 1,000 in five years. The 4% yield is the annual return.
Yield to maturity explained
Yield to maturity, or YTM, is the annualized return if you hold the bond to maturity and the issuer pays as promised. For a zero, YTM is easy to calculate from price and maturity like the formula above.
If the price goes up or down in the market, the YTM changes for a new buyer.
Tax treatment
Tax rules vary by country. Two common points to know:
- Imputed interest: Some tax systems treat the difference between purchase price and face value as taxable interest each year, even if you do not receive cash until maturity. In the US, this is called original issue discount or OID.
- State and local taxes: Municipal zeros may be exempt from federal or state tax. Check local rules.
Always check your tax advisor or local tax code before investing.
Risks
- Interest rate risk: Price falls if market rates rise. Longer maturities are more sensitive.
- Credit risk: Issuer might default. Treasury zeros are low risk. Corporate zeros can be risky.
- Inflation risk: Fixed payout loses purchasing power if inflation rises.
- Liquidity risk: Some zero-coupon bonds are harder to sell quickly at a fair price.
- Call risk: Some zeros can be callable, meaning the issuer can repay early, which may lower returns.
Note: Reinvestment risk does not apply for zeros because there are no coupons to reinvest.
Why investors buy zeros
- Predictable lump sum: Good for future expenses like tuition or a down payment.
- Higher price sensitivity: They magnify yield moves. Traders may use that feature.
- Simplicity: One cash flow is easy to plan for.
- Tax planning: Certain zeros tied to education or tax-exempt munis can be attractive.
Where to buy
- Brokerages: Most brokers sell government and corporate zeros.
- Treasury auctions: Governments sell short-term zeros directly.
- Mutual funds and ETFs: You can buy funds that hold many zeros for diversification.
- Financial advisors: Can help choose quality issues and maturities.
Example scenario
You want $10,000 in 10 years for college. A zero with face value $10,000 maturing in 10 years and yield 3% costs:
Price = 10000 / (1.03)^10 ≈ 7440
You buy the bond for about $7,440 today. In 10 years you get $10,000.
Pros and cons
Pros:
- Simple payout
- Predictable future value
- No reinvestment risk on coupons
Cons:
- Sensitive to interest rates
- May be taxed on imputed interest
- Lower liquidity for some issues
Quick checklist before buying
- Know the issuer and credit rating.
- Check tax rules for imputed interest.
- Match maturity to your goal.
- Compare yields with other fixed income options.
- Understand liquidity and call features.
Summary
A zero-coupon bond gives you a guaranteed lump sum at a set date in exchange for buying at a discount today. It is useful for planning fixed future costs. But it carries interest rate, inflation, and credit risks. Use them when you need a predictable payment and are comfortable with the risks.