Key Takeaways
- Pays no periodic interest; sold at a discount.
- Returns full face value at maturity.
- Ideal for fixed future financial goals.
- Price equals discounted present value of face.
What is Zero-Coupon Bond?
A zero-coupon bond is a debt security that does not pay periodic interest but is issued at a discount to its face value. Investors receive a single lump-sum payment at maturity, making the difference between purchase price and face value their total return.
Also known as discount or deep discount bonds, zeros contrast with traditional bonds by eliminating recurring coupon payments, focusing instead on growth through price appreciation.
Key Characteristics
Zero-coupon bonds have distinct features that differentiate them from other fixed-income securities:
- Issued at a discount: Sold below face value to compensate for lack of periodic interest.
- No periodic coupons: Interest accrues and compounds until maturity, resulting in a lump-sum payment.
- Fixed maturity payment: Investors receive the full face value at maturity, typically $1,000.
- Interest rate sensitivity: High Macaulay duration equal to maturity, increasing price volatility.
- Varied issuers: Governments, corporations, and municipalities may issue zeros, each with different risk profiles.
How It Works
Zero-coupon bonds compensate investors for waiting by selling at a discount and paying the full face value at maturity. The difference between purchase price and redemption value represents the investor’s yield, calculated using present value formulas.
These bonds are often created by stripping coupons from traditional bonds or issued directly with maturities ranging from short-term government bills to long-term corporate zero-coupon bonds. Their valuation reflects discounted cash flows based on the bond’s yield to maturity.
Examples and Use Cases
Zero-coupon bonds suit investors seeking predictable, lump-sum payouts without reinvestment risk. Common examples include:
- Government issues: U.S. Treasury securities like the 30-year Treasury stripped into zero-coupon components.
- Corporate bonds: Companies sometimes issue zeros to raise capital without immediate interest expenses.
- Airlines: While less common, firms like Delta may engage in bond issuance strategies including zero-coupon structures for financing flexibility.
- Bond funds: Exchange-traded funds such as BND include zero-coupon bonds within their portfolios to diversify interest rate exposure.
Important Considerations
While zero-coupon bonds offer a clear maturity value, they carry significant interest rate risk due to their long duration, meaning prices can fluctuate sharply with changing rates. Understanding your portfolio’s sensitivity through metrics like Macaulay duration is essential.
Additionally, zeros may be callable bonds, allowing issuers to redeem them early, which can affect expected returns. To balance risk and liquidity, consider combining zeros with other fixed-income assets or bond ETFs such as those listed in our best bond ETFs guide.
Final Words
Zero-coupon bonds offer a straightforward way to lock in a guaranteed lump-sum payment at maturity without reinvestment concerns. To make the most of this investment, compare yields and maturities across issuers to align with your financial goals.
Frequently Asked Questions
A zero-coupon bond is a type of debt security that does not pay periodic interest. Instead, it is sold at a discount to its face value, and the investor receives the full face value at maturity, with the difference representing the return.
Zero-coupon bonds generate returns by being sold at a deep discount to their face value. The investor's profit comes from the difference between the purchase price and the full face value paid at maturity.
They are sold at a discount because of the time value of money—investors prefer receiving money now rather than later. Issuers compensate by offering a higher payout at maturity instead of periodic interest payments.
There are government-issued zeros like U.S. Treasury bills and savings bonds, stripped bonds such as STRIPS that separate interest and principal, and corporate or municipal zero-coupon bonds, which generally offer higher yields but come with more risk.
The price is calculated as the present value of the face value discounted at the bond's yield to maturity (YTM). For example, with annual compounding, price equals face value divided by (1 + YTM) raised to the number of years until maturity.
Zero-coupon bonds eliminate reinvestment risk since there are no periodic payments to reinvest. They are ideal for fixed future expenses like college or retirement because they provide a lump sum at maturity.
Pension funds and insurance companies often invest in long-term zero-coupon bonds because their high duration helps match long-term liabilities and provides protection against interest rate changes.
Zero-coupon bonds carry interest rate risk because their prices are sensitive to rate changes, and corporate or municipal zeros also have default risk. Since they pay no interim interest, investors rely entirely on the issuer's ability to pay at maturity.
