Zero-Coupon Bond - The Pure Discount Instrument

By EC Assets Research Team, Fixed Income Strategy · Published 19 May 2026 · Updated 15 June 2026

Zero-Coupon Bond — A zero-coupon bond pays no periodic coupon. Instead, it is sold at a discount to face value and matures at face value. The return is purely the price appreciation from purchase to maturity.

Definition

A zero-coupon bond is a debt instrument that pays no periodic interest (coupon). Instead, the bond is issued or purchased at a discount to its face value (the amount payable at maturity), and the return to the investor consists entirely of the price appreciation from purchase to maturity.

A 30-year zero with $1,000 face value at 4% yield would currently trade at approximately:

Price = $1,000 / (1 + 0.04)^30 = $308.32

The investor pays $308.32 today and receives $1,000 in 30 years, with no payments in between. The yield is 4% annualised, but the cash flow profile is dramatically different from a coupon bond paying 4% twice per year for 30 years.

Zero-coupon bonds exist primarily in three forms: Treasury STRIPS (the largest market), zero-coupon municipal bonds, and corporate zero-coupon bonds (relatively niche). Each has distinct characteristics.

Treasury STRIPS: The Dominant Market

STRIPS (Separate Trading of Registered Interest and Principal Securities) were standardised by the US Treasury in 1985. The mechanism: regular Treasury bonds with periodic coupon payments are "stripped" into their component cash flows, each trading as a separate zero-coupon bond.

A 30-year Treasury paying $25 semi-annual coupons + $1,000 final principal becomes:

• 60 separate STRIPS for the coupon payments (one for each $25 coupon)
• 1 STRIPS for the final $1,000 principal payment

Each strip trades independently. The 60-coupon strips have maturities ranging from 6 months to 30 years; the principal strip matures at 30 years.

STRIPS are administered by the Treasury, settled through DTC, and have institutional liquidity. They are the dominant zero-coupon market globally.

Duration: The Extreme Case

[!key] Zero-coupon bonds have the maximum possible duration for any bond: duration equals time to maturity. A 30-year zero has 30-year duration. Compare to a 30-year coupon bond, whose duration is around 16-18 years (because the periodic coupon payments reduce the weighted average time to cash flow). The extreme duration makes zero-coupon bonds highly sensitive to interest rate changes. A 100 basis point rise in rates produces approximately 30% capital loss on a 30-year zero; a 100 basis point fall produces approximately 30% capital gain.

The mathematics:

For a zero-coupon bond:

• Duration = t (time to maturity in years)
• Modified Duration ≈ t / (1 + r)
• Convexity ≈ t² / (1 + r)²

For a 30-year zero at 4% yield:

• Duration = 30 years
• Modified Duration = 30 / 1.04 = 28.85 years
• Convexity = 30² / 1.04² = 832

A 100bp rate increase produces approximately:

• Linear estimate: -28.85% (just duration)
• Including convexity: ≈ -28.85% + 0.5 × 832 × 0.01² = -28.85% + 4.16% = -24.69%

Actual loss: ~25%. The convexity reduces the loss somewhat from the pure duration estimate.

Liability-Matching Applications

Zero coupons are ideal for matching specific future liabilities. Consider a pension fund that must pay $100M in 2050 to retiring employees:

Coupon bond approach. Buy long-dated Treasury bonds. The bonds pay periodic coupons that must be reinvested at unknown future rates. The final principal value depends on rates throughout the holding period. The pension faces reinvestment risk on the coupons and rate risk on the principal.

Zero coupon approach. Buy STRIPS maturing in 2050 with $100M face value. The pension knows exactly what it will receive in 2050 ($100M). No coupons to reinvest, no interim cash flow uncertainty. The match is exact.

The exactness of the match makes zero coupons the preferred instrument for liability-driven investing (LDI) strategies. The trade-off: zero coupons typically yield slightly less than equivalent coupon bonds (after adjusting for tax treatment), so the certainty comes at a small cost.

The Phantom Income Tax Issue

Zero-coupon bonds create a unique tax problem in the United States. The IRS treats the annual accretion toward face value as "imputed interest" - taxable income to the bondholder each year, even though no actual cash is received until maturity.

A 30-year zero purchased at $308 with $1,000 face value has $692 of cumulative appreciation. The IRS taxes approximately $692 / 30 = $23 per year (using the constant-yield method) as ordinary income. This creates a "phantom income" tax liability - the bondholder owes tax on income not yet received.

The practical implication: most institutional zero-coupon holdings are in tax-deferred accounts (pension funds, IRAs) where the imputed income doesn't trigger current tax. Taxable investors typically prefer coupon bonds where current income matches current tax liability.

Common Uses Beyond Liability Matching

Yield curve trading. STRIPS at various maturities allow precise positioning on the yield curve. Traders use STRIPS to bet on specific points of the curve without taking positions across the entire curve.

Duration management. Portfolio managers needing very long duration use STRIPS efficiently. A small notional STRIPS position provides the same duration as a much larger position in coupon bonds.

Hedging interest rate exposure. STRIPS are the most efficient instrument for hedging interest-rate-sensitive liabilities because their duration is precise and known.

Convexity arbitrage. The convexity of STRIPS is mathematically computed and traded against options markets where implied convexity may diverge from realised.

Common Misconceptions

"Zero coupons are riskless because no coupon reinvestment." Reinvestment risk is eliminated, but interest rate risk is amplified. The extreme duration makes capital loss potential larger than coupon bonds, not smaller.

"Zero coupons are exotic." Mainstream institutional fixed-income tool. STRIPS represent hundreds of billions in outstanding face value and trade with full institutional liquidity.

"Zero coupons are illiquid." US Treasury STRIPS have substantial liquidity, particularly in benchmark maturities (10, 20, 30 years). Corporate zero-coupon bonds may be less liquid but remain investable for institutional positions.

References

1. Fabozzi, F. J. (2021). Bond Markets, Analysis, and Strategies (10th ed.). MIT Press.
2. Tuckman, B., & Serrat, A. (2011). Fixed Income Securities (3rd ed.). Wiley.
3. Ilmanen, A. (2011). Expected Returns. Wiley.