Finance term
Zero-Coupon Bond
Also known as: zero coupon bond, discount bond, deep discount bond, accrual bond
Definition
A zero-coupon bond pays no periodic interest; instead, it is issued at a deep discount to face value and matures at par, with the investor's return being the difference. The IRS requires holders to accrue and pay tax on 'phantom income' (original issue discount, OID) annually under IRC Section 1272, even though no cash is received until maturity. See irs.gov/pub/irs-pdf/p1212.pdf for OID tax rules.
Detailed explanation
A zero-coupon bond is a debt instrument that makes no periodic coupon payments. Instead, it is issued at a price significantly below its face value (par), and the entire return is realized at maturity when the investor receives face value. A zero-coupon bond with a $1,000 face value and 10-year maturity at a 5% discount rate would be issued at approximately $614 — the investor's $386 gain accrues over 10 years.
**Original Issue Discount (OID) tax treatment under IRC Section 1272:** Despite receiving no cash, zero-coupon bond holders must include the annual accretion of OID as ordinary income each year under IRS rules. The IRS publishes a 'daily portions' calculation table in Publication 1212 (irs.gov/pub/irs-pdf/p1212.pdf). This creates a 'phantom income' problem — taxable income without corresponding cash flow — making zero-coupon bonds best suited for tax-advantaged accounts (IRAs, 401(k)s, education savings plans) or for tax-exempt investors.
**Use cases and issuers:** U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are the most common zero-coupon instruments — created by stripping coupons from standard Treasury bonds. Corporations also issue zero-coupon bonds (disclosed in SEC filings) when they prefer a lump-sum maturity payment structure. Municipal zero-coupon bonds (issued at OID) may have tax-exempt OID if the underlying interest would be tax-exempt.
**Interest rate sensitivity:** Zero-coupon bonds have the highest duration (price sensitivity to interest rate changes) of any bond structure. A 10-year zero-coupon bond has a Macaulay duration of 10 years — its entire cash flow arrives at year 10, making it more price-volatile than a coupon bond with the same maturity. This makes zeros valuable for duration-matching (pension funds, insurance companies) but risky in rising rate environments. See sec.gov/investor/pubs/zero.htm for the SEC's investor guidance on zero-coupon bonds.
◈ Worked example
- Treasury STRIPS: A 10-year Treasury STRIPS purchased at $614 matures at $1,000 in year 10 — a $386 gain ($38.60/year accrual). Held in a taxable account, the owner pays ordinary income tax on the annual OID accretion even without receiving cash. Held in an IRA, the OID accretes tax-deferred.
- Corporate zero-coupon: A company issues 7-year zero-coupon bonds at 60 cents on the dollar (40% discount). It receives $600M now and repays $1B at maturity. No cash interest outflows during the 7 years — beneficial for a capital-intensive growth phase. Investors accrue OID annually under IRC § 1272.
- Duration matching: A pension fund with $100M liability due in 10 years buys 10-year Treasury STRIPS. The single maturity cash flow matches the liability perfectly — no reinvestment risk (unlike coupon bonds, which must reinvest coupons at unknown future rates).
Common questions
The most-asked questions about Zero-Coupon Bond — answered straightforwardly.
Do I owe taxes on a zero-coupon bond if I receive no cash interest? +
Yes, for taxable accounts. The IRS treats the annual OID accretion as ordinary income under IRC Section 1272. IRS Publication 1212 provides annual OID amounts for listed instruments. Zero-coupon bonds are most tax-efficient when held in tax-advantaged accounts (IRA, 401(k)) where the phantom income is deferred or exempt. See irs.gov/pub/irs-pdf/p1212.pdf for the OID tax rules.
Why are zero-coupon bonds more volatile than regular bonds? +
Zero-coupon bonds have higher duration — a measure of price sensitivity to interest rate changes. Because all cash flow arrives at maturity (no interim coupon payments), the bond's price reacts more dramatically to rate movements. A 1% rate rise reduces a 10-year zero-coupon bond's price by approximately 10%, versus 7-8% for a 10-year coupon bond with the same maturity.
What are Treasury STRIPS? +
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon instruments created by stripping individual coupon payments and principal from standard Treasury bonds. Each stripped coupon becomes a separate zero-coupon instrument. STRIPS are backed by the full faith and credit of the U.S. government and are the most liquid zero-coupon market. See treasurydirect.gov for Treasury STRIPS information.
Further reading
This glossary entry is educational content. ClearValue Lending is a business & personal financing platform — not a lender, broker, or financial advisor. Specific product terms vary by lender; verify with the lender or issuer before applying. See privacy policy.