ZeroCoupon

Zero-coupon, or zerocoupon, bonds are debt instruments that do not pay periodic interest. They are issued at a discount to their face value and are redeemed at par at maturity. The investor’s return comes from the difference between the issue price and the maturity value, delivered as a single lump sum at the end of the term.

Pricing and risk: The price today reflects the time value of money. If a bond with face value F matures in n years is priced at P and yields y, the basic relationship is P ≈ F/(1+y)^n for annual compounding. Because there are no interim coupon payments, the entire yield is realized as price appreciation, making zero-coupon bonds more sensitive to changes in interest rates and effectively having a longer duration than a typical bond of the same maturity.

Common variants and examples: Government STRIPS or similar stripped securities, corporate zero-coupon bonds, and municipal zero-coupon issues are examples. There are also inflation-influenced versions, though they behave differently from standard nominal zeros.

Tax considerations: Tax treatment varies by jurisdiction. In many places, imputed (phantom) interest is taxable annually even though no cash is received. In the United States, federal income tax on imputed interest applies to zero-coupon bonds, including Treasury strips; state and local taxes depend on the issuing instrument and jurisdiction.

Advantages and disadvantages: Zero-coupon bonds can help with long-term, lump-sum goals and may offer favorable treatment for certain municipal issues. However, they exhibit greater price volatility with interest-rate moves, provide no periodic income, and can involve more complex tax reporting. They also carry issuer credit and liquidity risks similar to other bonds.

See also: STRIPS, discount bonds, and fixed-income investing.