Zero-Coupon Bond: Definition, How It Works, and How to Calculate

Key takeaways

• A zero-coupon bond pays no periodic interest (no coupons).
• It is sold at a deep discount and redeems at face (par) value at maturity.
• The investor’s return is the difference between purchase price and maturity value, which accrues as imputed (phantom) interest.
• Imputed interest is generally taxable each year even though no cash is received.
• Zero-coupon bonds are more price-sensitive to interest-rate changes than coupon bonds.

What is a zero-coupon bond?

A zero-coupon bond is a debt security that does not make periodic interest payments. Instead, it is issued (or created by stripping coupons from an existing bond) at a substantial discount to its face value and repays the full face value at maturity. The growth in value from purchase to maturity represents the investor’s return.

Alternate name: accrual bond.

How zero-coupon bonds work

• Issuance and pricing: A zero is sold below par. At maturity, the investor receives the bond’s face value.
• Imputed interest: The return accrues over the life of the bond and is treated as interest for accounting and tax purposes even though the investor receives no interim cash. This is often called “phantom interest.”
• Compounding: The implied interest compounds (commonly assumed semiannually or per the bond’s terms) and determines the bond’s price relative to its maturity value.
• Sources: Zero-coupon bonds can be issued by governments (including stripped Treasury securities), municipalities, and corporations. They also trade on secondary markets.

Pricing a zero-coupon bond

The price of a zero-coupon bond equals the maturity (face) value discounted by the required rate of return for the number of years to maturity:

Price = M / (1 + r)^n

where:
* M = maturity value (face/par value)
r = required annual rate of interest (decimal)
n = years until maturity

Example: To earn 6% annually on a bond with $25,000 par due in 3 years:

Price = 25,000 / (1 + 0.06)^3
(1.06)^3 ≈ 1.191016 → Price ≈ 25,000 / 1.191016 ≈ $20,991

At maturity the investor receives $25,000 and earns about $4,009 total, which equates to a 6% annual return.

You can rearrange the formula to solve for r (yield to maturity) if you know price, face value, and n.

Tax treatment

• Imputed interest on zero-coupon bonds is generally taxable as ordinary income in the year it accrues, even though no cash interest is received.
• Tax treatment may vary by issuer type: municipal zeros issued by state/local governments can be tax-exempt, and holdings in tax-advantaged accounts (IRAs, 401(k)s) avoid current-year tax on imputed interest.
• Rules for original-issue discount (OID) and accretion determine the annual taxable amount; investors should check current tax regulations or consult a tax professional.

How zeros differ from regular (coupon) bonds

• Coupon bonds pay periodic interest and return principal at maturity; zeros pay nothing until maturity.
• Price sensitivity: Zero-coupon bonds generally have higher interest-rate sensitivity (duration ≈ maturity) and thus greater price volatility for a given change in market rates.
• Reinvestment risk: Coupon bonds expose holders to reinvestment risk for coupon payments; zeros do not since there are no interim cash flows.

Uses and considerations

• Common uses: long-term savings goals (e.g., college funding), locking in a future cash amount, and portfolio duration management.
• Typical maturities: often long-term (10+ years), though short-term zero-coupon instruments exist.
• Advantages: predictable lump-sum payoff if held to maturity; can be purchased with a relatively small upfront investment that grows to a larger future value.
• Risks: significant price volatility before maturity, credit/default risk for corporate issues, and potential tax liability on imputed interest. Liquidity can vary by issue.

Bottom line

Zero-coupon bonds provide a simple way to invest for a known future cash need by buying a deep-discount instrument and receiving the full face value at maturity. They offer predictable accumulation if held to maturity but entail higher price volatility, potential phantom tax on accrued interest, and issuer credit risk. Consider tax status and investment horizon before including zeros in a portfolio.