Zero-coupon bonds explained

How zero-coupon bonds work

Conventional bonds pay coupons and return principal at maturity. A zero pays only principal — all return is embedded in the price appreciation from purchase discount to par.

Example: a 10-year Treasury STRIP with $100,000 face value might trade at $68,000 today. You pay $68,000 now and receive $100,000 in 10 years if held to maturity and the U.S. government does not default. The implied compound return is the yield to maturity on that single cash-flow stream.

Pricing and implied yield

Zero-coupon pricing is pure present value. For annual compounding:

Price = Face value / (1 + y)ⁿ

where y is the yield to maturity and n is years to maturity. Rearranging gives implied yield from market price. Because there is only one future payment, YTM is unambiguous — no coupon reinvestment assumptions muddy the calculation.

Price sensitivity is extreme. A 10-year zero with duration near 10 years loses roughly 10% of market value for each 1% parallel rise in yields (before convexity). A 5% coupon bond of the same issuer and maturity might have modified duration near 7 — the zero amplifies rate moves. That is the trade-off: precise terminal cash versus mark-to-market volatility.

• Longer maturity — deeper discount and higher duration.
• Higher market yields — lower price for same face value.
• Credit spread — corporate zeros trade at larger discounts than Treasuries; spread widening hits price like any bond.
• Liquidity — off-the-run STRIPS can gap on spread; use when-to-maturity ladders, not single illiquid lines.

Treasury STRIPS and separate trading of cash flows

STRIPS (Separate Trading of Registered Interest and Principal Securities) are U.S. Treasury zero-coupon bonds created when coupon-bearing Treasuries are stripped into individual zero-coupon components. Each coupon payment and the final principal payment becomes its own CUSIP trading at a discount to its nominal amount.

STRIPS are backed by the full faith and credit of the U.S. government — among the cleanest zeros for institutional liability matching. They are available in a wide maturity ladder from a few months to 30 years. Reconstitution allows recombination into coupon bonds if a dealer holds the full set of components.

For retail and cash-sleeve contexts, STRIPS compete with T-bills and Treasury notes. T-bills are short zeros in practice (sold at discount, mature at par within a year). STRIPS extend the same mechanics to multi-decade horizons without rolling bills every few months.

Phantom income and tax treatment

The tax code treats zero-coupon bonds as accruing interest annually even when you receive no cash. For taxable corporate zeros and Treasury STRIPS in a taxable account, original issue discount (OID) is imputed each year and taxed as ordinary interest income — so-called phantom income. You may owe tax on accreted interest while holding an underwater position after a rate spike.

• Treasury STRIPS in taxable accounts — annual OID income; no state tax on Treasuries in most states, but federal tax still applies on phantom accrual.
• Municipal zero-coupon bonds — OID often tax-exempt if the underlying muni is; verify AMT exposure on some issues.
• Tax-deferred wrappers — IRAs, 401(k)s, and 529 plans defer OID recognition; zeros are popular inside these shells.
• Corporate zeros — credit risk plus OID; rare for retail after defaults in the 1980s–90s zero fad.

Always model after-tax yield and liquidity for tax payments on phantom income before sizing a taxable zero ladder. A 4% pretax accrual is worthless if you must sell other assets each April to pay tax on income you never received in cash.

Portfolio use cases

Liability-driven investing (LDI)

Pension funds and insurers use zeros to immunize known future payouts. When a liability has a single dated cash need, a zero with matching maturity and face value eliminates reinvestment risk that coupon bonds introduce. See liability-driven investing for duration matching and surplus management.

Education and dated goals

Families targeting college tuition in a specific year sometimes ladder STRIPS or muni zeros inside 529 accounts so principal arrives near enrollment. The locked terminal value beats guessing reinvestment rates on coupon bonds over 15 years.

Bond ladders without coupon clutter

A pure zero ladder differs from a coupon ladder: each rung pays one lump sum on its maturity date with no intermediate flows to redeploy. Treasurers who want predictable principal on schedule without maintaining coupon sweep accounts often prefer zeros for the long end and T-bills for the near end.

Harbor Capital liability sleeve refactor

Harbor Capital replaced $1.2M of 2028–2035 coupon corporates in the pension overlay with Treasury STRIPS matched to benefit payment dates:

• Face-value targeting — each STRIP face equals the actuarial benefit due that month, not a rough notional.
• Tax-aware placement — taxable STRIPS moved to the qualified plan; muni zeros considered for taxable trust accounts after OID modeling.
• Duration cap — no single maturity beyond 12 years without board approval; longer zeros reserved for fully funded liabilities.
• Liquidity buffer — 6 months of benefits held in T-bills to avoid forced STRIP sales in a rate shock.
• Monthly mark — duration reported equals weighted average maturity; stress test +200 bps parallel shift on the zero book.

Reinvestment-risk Monte Carlo shortfall probability dropped from 12% to under 2% for the 2032 medical top-up tranche. Mark-to-market volatility on the zero book rose — reported surplus swung more quarter to quarter — but benefit security improved because terminal cash was no longer path-dependent.

Technique decision table

Common pitfalls

• Ignoring phantom tax — OID accrual in taxable accounts can force sales at the worst time.
• Confusing face value with cost — a $100k STRIP does not cost $100k today; size purchases on dollars invested.
• Duration shock — long zeros are not “safe” just because they are Treasuries; 20-year STRIPS can draw down 15–20% on a rate spike.
• Callable corporates masquerading as zeros — true zeros have no call; verify indenture on corporate discount bonds.
• Liquidity gaps — selling a STRIP before maturity crystallizes losses; keep a T-bill buffer for near-term needs.
• Reinvestment myth — zeros eliminate coupon reinvestment risk but not inflation risk; $100k in 2032 may buy less than today.
• Mixing zeros and FRNs without a policy — opposite rate sensitivities; document which sleeve hedges which risk.

Production checklist

• Define each dated liability with amount, currency, and tolerance band.
• Map liabilities to STRIP/muni-zero maturities; avoid over- or under-funding face values.
• Model OID and after-tax yield for every taxable lot.
• Place long zeros in tax-deferred accounts when possible.
• Hold 3–12 months of near-term needs in T-bills, not long STRIPS.
• Stress test portfolio: +100 bps and +200 bps parallel shift on zero book.
• Document weighted average maturity as duration proxy for reporting.
• Verify CUSIP, stripped vs reconstituted status, and secondary liquidity.
• Reconcile broker accrual reports with IRS OID statements annually.
• Review ladder annually; roll maturing STRIPS into next liability year.

Key takeaways

• Zeros trade at a discount and pay everything at maturity — no coupons, no reinvestment guesswork.
• Duration equals maturity, so zeros are the most rate-sensitive plain bonds for a given tenor.
• Treasury STRIPS are the institutional standard for dated U.S. dollar liabilities.
• Phantom OID income makes taxable zeros painful — prefer tax-deferred wrappers or coupon bonds in taxable accounts.
• Match face value to the liability, keep a T-bill buffer, and stress test before rate shocks bite.

Related reading

• Bond duration and interest rate risk explained — why zeros have maximum duration
• Yield to maturity explained — implied return on discount bonds
• Treasury bills explained — short-government discount instruments
• Liability-driven investing explained — matching assets to dated payouts