A zero-coupon security is a debt instrument that does not pay periodic interest, instead it is issued at a discount and pays its full face value at maturity.
A zero-coupon security is a type of bond or debt security that does not provide regular interest (coupon) payments. Instead, it is sold at a significant discount to its face (par) value and pays the full face value at maturity. The difference between the purchase price and the maturity value represents the investor's return. These securities are often considered lower-risk and are used by investors seeking predictable returns at a specified future date. They are typically issued by governments or corporations and can have maturities ranging from one year to several decades. Because they don’t provide interim interest payments, zero-coupon securities are more sensitive to interest rate changes than regular bonds. Zero-coupon securities are priced based on the time to maturity and the prevailing interest rates. Investors can estimate the yield through a yield-to-maturity (YTM) calculation, which assumes reinvestment is not necessary since there are no coupon payments. In a taxable account, investors may still owe taxes annually on the imputed interest, even though no cash is received until maturity. This creates what's known as “phantom income,” requiring tax planning for holders in non-tax-sheltered accounts.
Zero-coupon securities offer long-term predictability and are often used for aligning assets with specific future liabilities, such as funding generational trusts or tuition plans. Their price sensitivity to interest rate movements also makes them useful for hedging against inflation or deflation scenarios. For family offices, these instruments can serve as efficient tools for wealth transfer, future cash-flow planning, or locked-in yield generation within certain trusts. However, phantom income taxation necessitates careful tax consideration and alignment with overall tax strategy across the family’s entities.
An investor purchases a 10-year U.S. Treasury STRIP (a type of zero-coupon security) for $6,100. At maturity, they receive $10,000, resulting in a $3,900 gain. Even though the investor receives no interest along the way, the IRS requires them to pay taxes each year on an imputed amount of interest income (original issue discount), which is reported on Form 1099-OID.
Zero-Coupon Bond vs. Zero-Coupon Security
While 'zero-coupon bond' typically refers to a fixed-income instrument issued by governments or corporations without periodic interest payments, 'zero-coupon security' is a broader term that includes any debt instrument—such as notes or treasury strips—that doesn't pay interest over its life but is sold at a discount and redeemed at face value. All zero-coupon bonds are zero-coupon securities, but not all zero-coupon securities are technically bonds.
Do zero-coupon securities pay interest?
No, zero-coupon securities do not make periodic interest payments. Instead, they accrue interest over time, and the total return is realized as the difference between the purchase price and the face value at maturity.
Are zero-coupon securities taxed annually?
Yes, even though no income is received until maturity, the IRS requires holders of zero-coupon securities to pay annual tax on the imputed interest (or original issue discount). This is known as phantom income.
Are zero-coupon bonds safer than regular bonds?
Zero-coupon bonds from highly rated issuers like the U.S. Treasury are considered low-risk. However, they are more sensitive to interest rate changes than coupon-paying bonds, potentially increasing volatility in a portfolio.
