Zero-coupon bonds are debt securities you buy at a deep discount to face value, collect nothing on during their life, and redeem for the full face value at maturity. The gap between what you paid and what you receive is your return, compounded and delivered as one lump sum on a known date. That structure makes zeros an unusually clean tool for hitting a specific dollar target on a specific future date, but the price behavior and the tax treatment surprise a lot of first-time buyers.
How the Discount Turns Into Your Return
A traditional bond pays you periodic interest (coupons) and returns your principal at maturity. A zero strips those coupons out. You pay a discounted price upfront, receive nothing for years, and collect the face value on the maturity date.
Buy a 10-year zero with a $1,000 face value for $600, and you’ll see no deposits for a decade. On the maturity date, the issuer pays $1,000. The $400 difference is your interest, compounded across the full term and paid in a single shot. As long as you hold to maturity and the issuer doesn’t default, you know the exact dollar amount and the exact date.
The bond doesn’t jump from $600 to $1,000 at the end. Its value climbs each year through accretion, calculated on a set schedule using the constant yield method. Growth is slow early and accelerates in the later years, the way a savings account earns interest on its own interest.
How the Price Is Set
Three things determine the price: the face value, the prevailing market yield, and the years to maturity. Higher market rates push the price down because the discount has to be deeper to compete. Longer maturities push it down too, because your money is 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 effectively locked for the life of the bond. That is the structural advantage. Traditional bond investors receiving semiannual coupons have to figure out where to reinvest that cash, and if rates have fallen, the coupons get reinvested at lower yields. Zeros eliminate reinvestment risk because there is nothing to reinvest.
Why the Price Swings So Hard Before Maturity
The trade-off for locking in a yield is unusually sharp price sensitivity to rate changes while you hold the bond. Analysts measure this with duration, which estimates how much a bond’s price moves for each 1% shift in rates.
A zero’s duration is essentially equal to its time to maturity. A 20-year zero has a duration of about 20 years. A conventional 20-year bond paying regular coupons might have a duration of 10 to 12 years, because the coupon payments return cash along the way and cushion the price impact of rate moves. A zero offers no such cushion.
If you own a 20-year zero and rates rise 1%, the market price could fall by close to 20%. A 1% decline could boost it by a similar amount. If you plan to hold to maturity, those swings are paper. If you might have to sell, they are real losses waiting to happen.
The Phantom Income Tax Problem
Here is where zeros get uncomfortable in a taxable account. Even though you receive no cash until maturity, the IRS treats the annual increase in the bond’s value as taxable income each year. The tax code calls this Original Issue Discount (OID), defined as the difference between the 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 using 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 this phantom income because you owe tax on money you haven’t received.
Each year, your cost basis in the bond rises by the amount of 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 keeps you from being taxed a second time when you finally collect the face value. Your broker or the issuer reports the annual OID on Form 1099-OID, with the taxable amount in Box 1.3Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID
Retirement Accounts Solve It
The standard workaround is holding zeros inside a tax-advantaged retirement account. Inside an IRA or 401(k), OID accrues without triggering an annual tax bill. Traditional accounts tax you only when you withdraw in retirement; a Roth IRA makes the growth tax-free entirely if you meet the withdrawal rules. For a long time horizon, this combination removes the annual tax friction and preserves everything zeros are good at.
Municipal Zeros Get a Different Break
Zeros issued by state and local governments get a significant tax break. Under federal law, interest on state and local bonds is generally excluded from gross income, and that exclusion extends to the OID on municipal zeros, so you typically owe no federal tax on the annual accretion.4Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds If the issuer is in your home state, you may also avoid state income tax. Bonds from other states are often taxable at the state level.
One boundary: the federal exemption does not apply to private activity bonds that aren’t “qualified bonds,” arbitrage bonds, or bonds that fail registration requirements.4Office 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 treatment of any specific issue before assuming.
Selling Before Maturity
Sell early, and your gain or loss is measured against your adjusted basis, not the original purchase price. Because you have been reporting OID and stepping up basis each year, the taxable gain on an early sale is usually smaller than the raw price-minus-cost difference. Any gain above adjusted basis is generally treated as a capital gain.
The practical issue is liquidity. Corporate and municipal zeros can be thinly traded on the secondary market. You may not find a buyer at the price you want, and the bid-ask spread can eat into your return. Treasury STRIPS trade in a deeper market, but even STRIPS can move sharply when rates are rising. Zeros work best when you can commit to holding until maturity.
How to Buy Them
The most common zero-coupon bonds available to individual investors are Treasury STRIPS, which stands for Separate Trading of Registered Interest and Principal of Securities. The Treasury doesn’t 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.5TreasuryDirect. 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 must be in $100 increments.5TreasuryDirect. STRIPS
Corporate and municipal zeros are also available through brokers, though selection is smaller and liquidity is lower. Corporate zeros add issuer credit risk on top of interest rate risk. Municipal zeros add the work of verifying the tax-exempt status of the specific issue. Most retail buyers who want zero-coupon exposure stick with STRIPS for the combination of safety and straightforward tax treatment.
Risks Worth Knowing
Zeros concentrate several risks that are spread out or diluted in traditional bonds.
- Interest rate risk. Zeros have the highest duration of any bond with the same maturity. Rate increases can cause steep losses if you need to sell early, and the risk is most acute with long-dated zeros.
- Credit risk. Treasury STRIPS carry virtually no default risk because they’re backed by the U.S. government. Corporate and municipal zeros are different. If the issuer defaults, you lose what you were counting on, and unlike a coupon bond, you haven’t received any interest along the way to partially offset the loss.
- Inflation risk. Your return is locked in at purchase, so rising inflation erodes the purchasing power of the future lump sum. A $1,000 payment 20 years from now will buy less than $1,000 today, and you have no interim cash flows to reinvest at higher nominal rates.
- Liquidity risk. Corporate and municipal zeros can be hard to sell on the secondary market, and wide bid-ask spreads can meaningfully cut into your effective return.
- Phantom income tax burden. The annual OID obligation creates a real cash outflow on an investment producing no cash income. Investors who don’t plan for this in taxable accounts can find themselves short at tax time.
Who They Fit
Zeros make the most sense when you have a specific dollar amount you need on a specific future date. Funding a child’s first year of college in 15 years, meeting a balloon payment, or matching a known retirement liability are the classic use cases. Buy the bond today, and the math is done. No reinvestment decisions, no coupon management, no guessing about future rates.
They also work well inside retirement accounts, where the phantom income problem disappears. Long-dated Treasury STRIPS inside a Roth IRA give an investor in their 30s or 40s a guaranteed nominal return, no annual tax friction, and no reinvestment risk. That’s a clean combination for the conservative portion of a portfolio.
Investors who need flexibility or who might sell early should think twice. High duration, potential liquidity issues, and annual tax obligations on unreceived income make zeros a poor fit for money you might need before the maturity date. The structure rewards patience and punishes early exits.