Zero-Coupon Bond

A zero-coupon bond is a debt security that makes a single payment, the face value, on its maturity date, and none before. The SEC's investor glossary puts it this way: "Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due." The MSRB's definition adds the mechanism: it is "An original issue discount bond on which no periodic interest payments are made but which is issued at a substantial discount from par, accreting (at the rate represented by the offering yield at issuance) to its full value at maturity."

On spelling, the SEC and MSRB write "zero coupon bond" without a hyphen and the Treasury writes "zero-coupon security" with one; the two are the same instrument. The name itself is descriptive: the coupon rate page explains that a bond's coupon is its stated periodic interest, and a zero-coupon bond is the case where that rate is zero.

Where zeros come from. The SEC notes that investors "can purchase different kinds of zero coupon bonds in the secondary markets that have been issued from a variety of sources, including the U.S. Treasury, corporations, and state and local government entities." The Treasury's contribution is not an issue of new bonds at all but a program that takes existing ones apart.

Treasury STRIPS. The name stands for Separate Trading of Registered Interest and Principal of Securities. TreasuryDirect explains: "The idea of STRIPS is that the principal and each interest payment become separate securities that are treated individually. Each separated piece is a zero-coupon security that matures separately and, has only one payment." Its example is a bond with ten years remaining, which consists of one principal payment and twenty semiannual interest payments; stripped, "The one original security is now 21 separate new securities" with their own CUSIP identifiers. Three rules govern the program. First, eligibility: "Treasury securities with a fixed-principal, such as notes, bonds, and TIPS are eligible and may be stripped. Bills and FRNs can't be stripped." Second, access: "You can buy, hold, sell, and redeem STRIPS only through a financial institution, a broker, or dealer who handles government securities." They cannot be held in a TreasuryDirect account. Third, size: "The minimum face amount needed to STRIP is $100, and any par amount above that minimum must be a multiple of $100." A stripped security can also be reassembled if one institution gathers every remaining piece. The Treasury bond page mentions STRIPS in passing; this is the fuller account of what a holder actually owns.

Corporate and municipal zeros. A corporation can issue a bond with no coupon directly, and so can a state or local government. In the municipal market the MSRB distinguishes a traditional zero from a capital appreciation bond, which is economically similar but structured so that "the investment return is considered to be in the form of compounded interest rather than accreted original issue discount"; the difference matters to the issuer's debt limit more than to the holder's return.

Why the price moves more. A coupon bond returns part of its value every six months, so only part of it is exposed to a change in rates for the full term. A zero returns everything on the last day, so all of it is exposed for the full term. The SEC states the consequence: "Because zero coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market." The bond duration page explains why a zero is the one case where duration equals maturity. The flip side is that a zero held to maturity has no coupons to reinvest and therefore locks in its purchase yield, a point the reinvestment risk page makes.

The planning use, and the tax catch. The SEC observes that long maturities "allow an investor to plan for a long-range goal, such as paying for a child's college education," because "an investor can put up a small amount of money that can grow over many years" to a known sum on a known date. The catch is in the same entry: "although no payments are made on zero coupon bonds until they mature, investors may still have to pay federal, state, and local income tax on the imputed or "phantom" interest that accrues each year." The tax law treats the discount as interest earned over the life of the bond; Publication 550 states that "All debt instruments that pay no interest before maturity are presumed to be issued at a discount. Zero coupon bonds are one example of these instruments." That accrual is original issue discount, reported each year on Form 1099-OID, and the original issue discount page covers how it is computed and the exceptions. Holding a taxable zero inside a tax-deferred account, or buying a municipal zero whose accrual is exempt, are two ways to avoid paying current tax on income not yet received; the SEC's entry mentions the second.

The buyer pays a discounted price today and receives the face value at maturity. The gap between the two, spread over the term, is the yield. Each year the bond's value moves up toward face value along the curve implied by that yield, a process the MSRB calls accretion, and each year's accretion is the amount the holder reports as interest income even though no cash arrives.

A hypothetical example with an invented yield. Devon buys a zero-coupon bond with a $10,000 face value maturing in 10 years, priced to yield 4 percent compounded annually. The price is $10,000 ÷ 1.04^10. Since 1.04^10 is about 1.4802, the price is about $6,755.64.

Nothing is paid for ten years. In the first year the bond accretes toward face value by roughly 4 percent of its starting value: 0.04 × $6,755.64 = about $270.23. That is the interest Devon reports for the year, with no matching cash payment; his cost basis in the bond rises by the same amount, so that the accreted value is not taxed a second time when the bond matures or is sold. In the final year the accretion is about 0.04 × $9,615.38 = $384.62, because the base has grown. Over the full ten years the accretion totals $10,000 − $6,755.64 = $3,244.36, all of it taxed as it accrued.

At maturity Devon receives $10,000, which by then equals his adjusted basis, so there is no gain or loss on the repayment. If instead he sold after three years and rates had risen, the price would sit below the accreted value and he would have a capital loss on the sale even though he had been reporting interest income each year. That combination, taxable income without cash and a price that can fall below the accreted value, is why zeros suit being held either to maturity or inside a tax-deferred account.

Pros

• Delivers a known sum on a known date, which suits a dated goal such as a tuition bill or a planned purchase.
• Held to maturity, a zero locks in its purchase yield because there are no coupons to reinvest at whatever rates prevail later.
• Treasury STRIPS carry the full faith and credit of the United States and trade in $100 multiples, so the exposure can be sized to the goal.
• A small outlay today buys a much larger face value later, which makes the growth visible and the plan easy to hold to.

Cons

• The accreted discount is taxed every year as interest in a taxable account, with no cash from the bond to pay the tax.
• Prices swing more than coupon bonds of the same maturity, so a zero sold before maturity after rates rise can produce a capital loss on top of the interest already taxed.
• No income arrives during the holding period, which makes zeros a poor fit for anyone who needs the bond to pay bills along the way.
• STRIPS cannot be bought or held in a TreasuryDirect account; they require a brokerage or dealer relationship.
• For a corporate zero, the whole return depends on the issuer being able to pay one large sum on one date years away, so credit matters more than for a bond that has been returning cash all along.