Zero-Coupon Bonds Explainer
A zero-coupon bond makes no periodic interest payments. Instead, it is generally issued or purchased below its maturity value, and the difference between the price and the amount received at maturity represents the investor’s return before taxes, fees, and default risk.
The discount accretes over time using the security’s yield conventions. Because all promised cash arrives at maturity, a zero-coupon bond typically has more duration and price sensitivity than a coupon bond with the same maturity and credit quality.
The absence of coupons removes the need to reinvest periodic interest, which can help match a known future liability. It also concentrates repayment risk at the end. Selling early exposes the investor to current rates, credit spreads, and market liquidity.
Tax rules may require recognition of imputed interest each year even though no cash is received, creating phantom income. Municipal zeros can differ, and some securities are callable at an accreted value. Investors should review issuer credit, maturity amount, tax status, and redemption provisions.
Return comes from the discount accreting toward maturity value.
Cash generally arrives only at the end.
All cash flow is concentrated at maturity.
Long zeros can move sharply when yields change.
Imputed interest can be taxable during the holding period.
Tax and call terms must be checked security by security.
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