Zero-coupon bond
What is Zero-coupon bond?
A zero-coupon bond pays no periodic coupon and is normally issued or traded below the principal amount expected at maturity.
How zero-coupon bonds work
Investor return comes from the difference between purchase price and the amount paid at maturity, assuming full payment. The discount accretes over time under the relevant yield convention. Zeros can be issued directly or created by separating coupon and principal cash flows from another bond. They concentrate cash flow at one future date.
Example
An investor pays $800 for a five-year zero expected to pay $1,000 at maturity. No cash coupon is received during the five years. The annualized yield is determined by the compounding convention and exact dates. If market yields rise after purchase, the present value of the distant $1,000 declines and the market price falls.
Duration and reinvestment
A standard zero's Macaulay duration equals its maturity because all cash arrives at the end. It usually has greater rate sensitivity than a coupon bond with the same maturity and yield. Because there are no interim coupons, it has no coupon reinvestment risk, but the entire principal remains exposed to issuer credit until maturity.
How to interpret it
Match maturity cash flow with a known liability when issuer credit and currency are suitable. Review yield, duration, credit, liquidity, and tax. Some jurisdictions tax imputed interest before cash is received, creating a tax funding issue. Inflation can materially reduce the purchasing power of the fixed maturity payment.
Limitations
The absence of coupons does not mean the bond has no income or risk. Price can be highly volatile when maturity is long. Default can impair the single expected payment, and selling before maturity exposes the investor to prevailing yields and liquidity. Callable or structured zeros may not deliver the simple contractual path described here.
Practical checklist
Confirm maturity amount, settlement price, yield convention, issuer, seniority, currency, and any call or conversion features. Calculate duration and scenario prices, review tax treatment of discount accretion, and assess secondary-market liquidity. If used for liability matching, test default, inflation, and timing differences and avoid assuming that maturity value is contractually guaranteed in every circumstance.
Also known as: discount bond, zero
Sources and further reading
- Corporate Bonds, Investor.gov, U.S. Securities and Exchange Commission