A zero-coupon note is a debt security issued at a discount and repaid at face value at maturity, with no periodic interest payments.
A zero-coupon note is a type of fixed-income security that does not make regular interest payments (coupons) to investors. Instead, it is issued at a deep discount to its face (par) value and pays the full face amount upon maturity. The difference between the purchase price and the par value represents the investor’s return. Investors are essentially lending money to the issuer and receiving interest income in the form of capital appreciation. These notes are often short- to medium-term in duration and can be issued by corporations, municipalities, or financial institutions. Zero-coupon notes are valued based on the present value of their face amount discounted at an appropriate interest rate. They are sensitive to changes in interest rates, as the entire return depends on the time value of money over the investment horizon. Often used for liability matching or tax planning, they are particularly attractive to investors with long-term horizons who do not require immediate income and prefer predictable, lump-sum payouts.
Zero-coupon notes can play a strategic role in a family office's fixed-income allocation, offering predictable cash flows for future liabilities, such as education or estate planning expenses. Since these notes accumulate interest internally and have no periodic coupon payments, they can help simplify cash flow management and align with long-term wealth transfer objectives. They also introduce unique tax and reporting considerations, as accrued interest may be taxable annually despite no cash being received. This makes coordination with tax advisors and the careful selection of account types (e.g., tax-deferred vehicles) essential to avoid unintended tax burdens.
Suppose a family office purchases a zero-coupon note with a face value of $1,000 maturing in 5 years, issued at $800. No interest is paid annually. At the end of 5 years, the family office receives the full $1,000, realizing a $200 gain. The implicit interest rate is approximately 4.56%, compounded annually. For planning purposes, this instrument could be used to fund a beneficiary’s college tuition in exactly five years, aligning asset maturity with liability.
Zero-Coupon Note vs. Zero-Coupon Bond
While a zero-coupon note and a zero-coupon bond share similar characteristics (both make no periodic interest payments and are issued at a discount), they mainly differ in maturity length. Zero-coupon notes typically have short- to intermediate-term maturities (typically under 10 years), while zero-coupon bonds usually have longer maturities, often 10+ years. The underlying issuing entity (e.g., corporation vs. government) and specific tax treatments may also differ.
Are zero-coupon notes taxed annually even if no interest is received?
Yes, in taxable accounts, the IRS requires holders of zero-coupon notes to pay income tax each year on the 'imputed interest'—the amount of interest that accrues annually—even though no actual payment is received. This is referred to as 'phantom income.'
Can zero-coupon notes be used in retirement accounts?
Yes, zero-coupon notes are commonly used in tax-advantaged accounts like IRAs or 401(k)s to avoid current-year taxation on imputed interest. This allows investors to defer taxes until funds are withdrawn and better align maturity with retirement income needs.
Are zero-coupon notes risk-free investments?
Not necessarily. While some are issued by creditworthy entities, such as the U.S. Treasury, others may carry credit risk depending on the issuer’s financial stability. Additionally, they have high duration risk, meaning they are more sensitive to interest rate fluctuations than traditional coupon-bearing bonds.
