A zero-coupon bond is a debt security you buy at a discount to its face value, receive no interest payments on, and redeem for the full face value on a set maturity date. The gap between what you pay and what you collect is your return. That structure makes zero coupon bonds useful when you need a known dollar amount on a known future date, but it also concentrates a few risks and creates a tax quirk that catches new buyers off guard.
What a Zero-Coupon Bond Is
A traditional bond pays you periodic interest (the coupons) and returns your principal at maturity. A zero-coupon bond removes the coupons. You pay a discounted price today, receive nothing for years, and collect the full face value in one payment when the bond matures.
A simple example: you buy a 10-year zero-coupon bond with a $1,000 face value for $600. No checks arrive for a decade. On the maturity date, the issuer pays you $1,000. The $400 gap is your interest, compounded across the life of the bond and paid all at once.
The bond’s value doesn’t leap from $600 to $1,000 at the end. It grows gradually each year through accretion, calculated using the constant yield method. Growth is slow early and accelerates later, the way a compounding savings balance does.
How the Price and Yield Are Set
Three variables drive the purchase price: face value, the prevailing market yield, and time to maturity. Higher market rates force a deeper discount, because the bond has to be cheap enough to compete with current yields. Longer maturities also push the price down, because the money stays tied up longer and compounding has more time to work. A 30-year zero sells at a much steeper discount than a 5-year zero at the same yield.
Once you buy, your yield is locked in for the life of the bond. That is the structural appeal. A traditional bondholder receiving semiannual coupons has to keep finding places to reinvest that cash, and if rates fall, those reinvestments happen at lower yields. Zero-coupon bonds have no interim cash to reinvest, so reinvestment risk disappears.
Why Prices Swing So Much Before Maturity
Locking in a yield has a cost: the bond’s market price is unusually sensitive to interest rate changes while you hold it. Analysts measure this sensitivity with duration, which estimates how much a bond’s price moves for each 1% shift in rates.
A zero-coupon bond’s duration is roughly equal to its time to maturity. A 20-year zero has a duration of about 20 years. A traditional 20-year bond paying regular coupons might have a duration closer to 10 to 12 years, because the interim coupons return cash and cushion the price impact of rate moves. Zeros have no such cushion.
If you own a 20-year zero and market rates jump 1%, the resale price can fall by roughly 20%. A 1% decline in rates can push it up by a similar amount. If you hold to maturity, these are paper swings that resolve at the redemption date. If you might sell early, they are real risk.
The Phantom Income Tax Problem
Zero-coupon bonds create a tax situation that surprises many first-time buyers. Even though no cash arrives until maturity, the IRS treats the annual increase in the bond’s value as taxable income in the year it accrues. The tax code calls this Original Issue Discount, defined as the difference between face value and the price at which the bond was originally issued.1Office of the Law Revision Counsel. 26 U.S. Code 1273 – Determination of Amount of Original Issue Discount
You must include a portion of that OID in your gross income each year, calculated under the constant yield method.2Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount It is taxed at ordinary income rates, not the lower capital gains rate. Investors call it “phantom income” because you owe tax on money you have not actually received.
Your cost basis in the bond rises each year by the OID you report.2Office of the Law Revision Counsel. 26 U.S. Code 1272 – Current Inclusion in Income of Original Issue Discount That adjusted basis prevents you from being taxed a second time on the same income when the bond pays out at maturity. Your broker or the issuer reports each year’s OID on Form 1099-OID, with the taxable amount in Box 1.3Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID The IRS walks through the calculation and basis adjustments in Publication 1212.4Internal Revenue Service. Publication 1212 (12/2025), Guide to Original Issue Discount (OID)
If you sell before maturity, gain or loss is measured against your adjusted basis rather than your original purchase price. Because you have already reported OID as income and stepped up your basis, the taxable gain on an early sale is usually smaller than the raw price difference suggests. Gain above the adjusted basis is generally a capital gain.
Municipal Zeros and Retirement Accounts
There are two clean ways to sidestep phantom income.
The first is a tax-advantaged retirement account. Inside a traditional IRA or 401(k), OID accrues without an annual tax bill, and you pay tax only on withdrawals. Inside a Roth IRA, qualifying withdrawals are tax-free entirely. A long-dated Treasury zero held in a Roth combines a guaranteed nominal return with no annual tax friction.
The second is municipal zero-coupon bonds. Interest on state and local bonds is generally excluded from federal gross income, and that exclusion extends to the OID on municipal zeros.5Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds If you live in the issuing state, you may avoid state income tax as well. Bonds issued by other states are often subject to your home state’s income tax.
One caveat: the federal exemption under Section 103 does not cover private activity bonds that are not “qualified bonds,” arbitrage bonds, or bonds that fail registration requirements.5Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds Most general obligation and essential-purpose revenue bonds qualify, but confirm the status of any specific issue before assuming the OID is tax-free.
How to Buy Zero-Coupon Bonds
The most widely held zero-coupon bonds among individual investors are Treasury STRIPS. The name stands for Separate Trading of Registered Interest and Principal of Securities. Treasury does not issue zeros directly. Financial institutions take existing Treasury notes and bonds and separate each interest payment and the principal payment into individual zero-coupon securities.6TreasuryDirect. STRIPS
You cannot buy STRIPS through TreasuryDirect. They are available only through a financial institution, broker, or government securities dealer. The minimum face amount for stripping a Treasury security is $100, and any amount above that must be in $100 increments.6TreasuryDirect. STRIPS
Corporate and municipal zeros are also sold through brokers, though the selection is narrower and secondary-market liquidity is lower. Corporate zeros add issuer credit risk on top of interest rate risk. Municipal zeros require you to verify the tax-exempt status of the specific issue. Most retail buyers who want zero-coupon exposure choose Treasury STRIPS for the combination of safety and straightforward tax treatment.
Risks to Weigh Before Buying
Zero-coupon bonds concentrate several risks that are spread out or muted in traditional coupon bonds.
- Interest rate risk is the largest. Duration equals maturity, so long-dated zeros can lose substantial value on the secondary market when rates rise.
- Credit risk varies by issuer. Treasury STRIPS carry the backing of the U.S. government. Corporate and municipal zeros do not, and if an issuer defaults you have received no interim interest to offset the loss.
- Inflation risk is real. Your return is fixed in nominal dollars at purchase, and rising inflation erodes what that future lump sum will buy.
- Liquidity risk affects corporate and municipal zeros in particular. Even when a buyer exists, a wide bid-ask spread can eat into your return.
- Phantom income is a cash-flow problem. In a taxable account, you owe tax each year on accrued OID even though no money has arrived from the bond.
When a Zero-Coupon Bond Fits
Zero-coupon bonds fit best when you have a specific dollar amount you need on a specific future date. Funding a year of college tuition 15 years out, matching a balloon payment, or covering a known retirement liability are the classic cases. You buy today, the math is settled, and there are no coupon reinvestment decisions along the way.
They also fit well inside retirement accounts, where the phantom income issue disappears. A long-dated Treasury STRIP inside a Roth IRA gives you a guaranteed nominal return, no annual tax drag, and no reinvestment risk.
Zeros fit poorly for money you may need before maturity. High duration means large paper swings, secondary-market liquidity can be thin outside of Treasury STRIPS, and the annual tax on unreceived income creates real cash-flow friction in a taxable account. The structure rewards patience and punishes early exits.