What Is a Zero-Coupon Bond?
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Aja McClanahan
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Emily Gadd
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A zero-coupon bond is a type of bond that does not pay periodic interest — or coupon payments — like traditional bonds.
Instead, they are issued at a steep discount and provide a return to the investor by paying out the difference between the purchase price and the bond’s par, or face value, at maturity.
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How Does a Zero-Coupon Bond Work?
Investors purchase zero-coupon bonds below amount the bond will be worth when it reaches maturity. When the bond comes due, the investor collects its face value and pockets the difference.
For example, if you buy a zero-coupon bond with a face value of $10,000 and a 10-year maturity at a discount price of $6,500, you’ll get back your $6,500 principal plus $3,500 in profit when the 10-year term is up.
Since zero-coupon bonds do not pay interest and generate their returns through their reduced purchase price, they are sometimes referred to as discount bonds or simply zeros.
Key Features of Zero Coupon Bonds
- No periodic interest payments – You receive a lump sum payment at maturity.
- Issued at a discount – Investors buy them for less than their face value.
- Fixed return – The bond’s value gradually increases over time until maturity.
- Best for long-term goals – Ideal for retirement savings, education funds, or estate planning.
Who Do Zero-Coupon Bonds Work Best For?
Since zero coupon bonds don’t pay out regular income like traditional bonds, it’s best suited for investors who don’t need immediate cash flow.
Investors purchase zero-coupon bonds because they guard their principal and deliver predictable returns over long periods — their terms are usually a decade or more.
Some investors include discount bonds in their portfolios to add a different kind of exposure to already-diverse bond holdings. Others use them in pursuit of long-term financial goals like saving for college. Since they provide known and fixed returns for set periods, investors can expect their capital to be intact when they need it on a specific target date in the future.
Types of Zero Coupon Bonds
There are three main types of zero coupon bonds, each with different risk levels and tax benefits.
| Type of Bond | Issuer | Risk Level | Tax Benefits |
|---|---|---|---|
| U.S. Treasury Zero Coupon Bonds | U.S. government | Low (backed by the U.S. Treasury) | Interest is taxable but exempt from state/local taxes |
| Corporate Zero Coupon Bonds | Private companies | Medium to High (depends on issuer’s credit rating) | Taxable at federal, state, and local levels |
| Municipal Zero Coupon Bonds | State & local governments | Low to Medium (depends on the issuing government) | May be tax-free at state and local levels if purchased within the same state |
If you’re investing in zero-coupon bonds for tax-advantaged accounts like an IRA, consider corporate zero-coupon bonds to maximize growth without worrying about taxes on interest accruals.
Risks of Zero Coupon Bonds
While zero-coupon bonds are safe investments, they come with some risks to consider:
- Interest rate risk – If interest rates rise, the market value of your bond can decline, making it harder to sell before maturity.
- No cash flow – Since there are no interest payments, you won’t receive regular income like traditional bonds.
- Inflation risk – Over time, inflation may reduce the purchasing power of your final payout.
- Taxable interest (phantom income) – Even though you don’t receive interest payments, the IRS taxes the accrued interest annually.
If taxes on “phantom income” are a concern, consider holding zero coupon bonds in tax-advantaged accounts like an IRA or 401(k).
Zero-Coupon Bonds vs. Traditional Bonds
Zero-coupon bonds are different from traditional bonds because they don’t make regular interest payments. Instead, they are sold at a discount and pay their full value at maturity.
| Feature | Zero-Coupon Bonds | Traditional Bonds |
|---|---|---|
| Interest Payments | None (paid at maturity) | Paid regularly (monthly, semi-annually) |
| Risk Level | Varies (depends on issuer) | Varies (depends on issuer) |
| Best for Investors Who | Want long-term growth | Need consistent income |
| Market Price Fluctuations | More volatile due to interest rate changes | Less volatile |
If you need a steady income, go for traditional bonds. If you want long-term growth, zero-coupon bonds may be the better option.
Maturity and Redemption of Zero Coupon Bonds
When a zero-coupon bond matures, the investor can redeem it for its full face value, which is higher than the purchase price since no periodic interest payments were made.
Steps to Redeem a Zero Coupon Bond
- Check the bond’s maturity date – Ensure it has fully matured to receive the maximum payout.
- Contact the issuer – Treasury bonds can be redeemed via TreasuryDirect, while corporate and municipal bonds must be redeemed through a broker or financial institution.
- Report the earnings on your taxes – The difference between your purchase price and maturity value is considered interest income.
Are Zero Coupon Bonds Right for You?
Zero-coupon bonds offer the advantage of predictable returns and are ideal for long-term goals, like saving for college or retirement. However, they come with risks, such as price volatility and potential tax implications on accrued interest. These bonds are best suited for patient, long-term investors and those with tax-advantaged accounts. Before investing, carefully consider your financial goals, risk tolerance, and the overall balance of your portfolio.
If you’re considering zero-coupon bonds, consult a financial advisor or check out investment platforms that offer U.S. Treasury bonds and municipal securities.
FAQs About Zero-Coupon Bonds
Although the basic idea behind investing in bonds can be simple to understand, there are still many common questions surrounding them, in part because there are so many different kinds. Here are the answers to some of the most frequently asked questions regarding zero-coupon bonds:- What is the minimum investment required for zero-coupon bonds?
- It depends on the issuer, but U.S. Treasury zero coupon bonds can be purchased for as little as $1,000.
- How do zero coupon bonds increase in value over time?
- Zero coupon bonds accrue interest instead of paying periodic payments, gradually increasing in value until maturity.
- Are zero-coupon bonds safe investments?
- Yes, U.S. Treasury zero coupon bonds are extremely safe. Corporate and municipal bonds carry some credit risk, depending on the issuer.
- How are zero coupon bonds taxed?
- Even though they don’t pay interest annually, the IRS taxes the accrued interest as income each year. However, they may be tax-exempt if held in IRAs or other tax-advantaged accounts.
- Can I sell a zero coupon bond before it matures?
- Yes, but the price depends on market conditions. If interest rates rise, the bond’s value may drop, meaning you could sell at a loss.
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- Financial Industry Regulatory Authority "The One-Minute Guide to Zero Coupon Bonds."
- Investor.org "Bonds, Selling Before Maturity"
- Investor.org "Zero coupon bond"
- U.S. Department of the Treasury "Interest Rate Statistics"
- TreasuryDirect "Continued Treasury Zero Coupon Spot Rates"
