What is a Zero Coupon Bond?
A zero coupon bond (also called a discount bond or pure discount bond) pays no periodic interest. Instead, it is issued at a deep discount to face value and repays the full face value at maturity. The investor's return equals the difference between the purchase price and face value. US Treasury STRIPS and US savings bonds are common examples.
Present value formula: PV = FV รท (1 + r)^n. YTM formula: YTM = (FV รท PV)^(1รทn) โ 1. Zero coupon bonds have high duration โ their price is very sensitive to interest rate changes. A bond maturing in 20 years will lose far more value per 1% rate rise than a 2-year bond.
Frequently Asked Questions
In the US, the imputed interest on zero coupon bonds is taxable each year even though no cash is received โ this is called "phantom income." This makes them better suited for tax-advantaged accounts like IRAs.
STRIPS (Separate Trading of Registered Interest and Principal Securities) are US government zero coupon bonds created by stripping coupons from Treasury bonds. They are backed by the full faith and credit of the US government.