Glossary
Zero-coupon bond
A bond that pays no periodic interest, sold at a deep discount and repaid at full face value at maturity, so the discount is the return.
On this page
A zero-coupon bond pays no interest along the way. You buy it for less than its face value and receive the full face value at maturity; the gap between the two is your entire return. Treasury bills work this way over short periods, and long-dated zeros, such as Treasury STRIPS, extend the same idea out decades. Investors use them to fund a known future expense, because the amount and date of the single payment are fixed in advance.
How it works
That sensitivity is the defining trait. With no coupons to return cash early, a zero's duration equals its maturity, so long zeros swing more with interest rates than any coupon bond of the same maturity.
What to know before buying
Held to maturity, a zero locks in its yield with no reinvestment risk, since there are no coupons to reinvest. Sold early, it can show large gains or losses. In the US, holders of most taxable zeros must report part of the discount as income every year, called original issue discount or "phantom income," even though no cash arrives until maturity. That is why many investors hold them in IRAs or other tax-deferred accounts, or prefer tax-exempt municipal zeros.