A zero-rate bond is a fixed-income security that pays no periodic interest and is issued at a deep discount to its face value, with the full principal repaid at maturity.
A zero-rate bond, also known as a zero-coupon bond, does not make regular interest payments (coupons) to investors. Instead, it is issued at a discount to its face (par) value and provides a return to the holder through the appreciation in value as it approaches maturity. The difference between the purchase price and the face value represents the investor's profit. In financial markets, zero-rate bonds are used to lock in long-term yields and are often issued by governments and corporations. They are priced based on the present value of their face amount using a zero rate curve, which reflects the interest rate applicable to a given time period in the future. Because these bonds do not generate periodic income, they are more sensitive to interest rate changes and are commonly used in strategies requiring precise duration targeting. Zero-rate bonds are popular in interest rate modeling and yield curve construction since their pricing inherently reflects the pure time value of money. They can be bought and held to maturity for guaranteed returns or traded on secondary markets, appealing to investors who prefer simplicity and predictable outcomes.
Zero-rate bonds can play a critical role in liability-driven investment strategies, particularly for intergenerational planning or charitable trusts where matching asset cash flows to future obligations is important. Their known return profile and zero-coupon feature make them ideal for long-dated funding needs, including educational costs or legacy gifts. In a family office, these bonds offer tax deferral benefits since interest income is accrued but not received annually (unless required to be reported under rules like original issue discount treatment). This can influence tax planning, wealth transfer strategies, and governance decisions around the preservation and growth of capital across generations.
Consider a 10-year U.S. Treasury zero-rate bond with a face value of $10,000 issued at $6,139.13. The investor receives no interest payments during the 10 years. Instead, they receive the full $10,000 at maturity, achieving an annual yield of 5%. The return is thus calculated entirely from the bond being issued at a discount and redeeming at full face value.
Zero-Coupon Bond vs. Coupon Bond
While a zero-rate bond does not pay periodic interest, a coupon bond provides regular interest payments (coupons) over the bond's life. A zero-coupon bond is sold at a discount and matures at face value, whereas coupon bonds may trade at, above, or below par depending on their coupon rate compared to the market rate. Zero-rate bonds are used more in precise duration strategies due to their single cash flow characteristic.
Are zero-rate bonds the same as zero-coupon bonds?
Yes, in most contexts, 'zero-rate bond' is synonymous with a zero-coupon bond. Both refer to bonds issued at a discount and maturing at face value, without periodic interest payments.
Do zero-rate bonds generate taxable income even without cash flow?
Yes. In many jurisdictions, investors must report imputed interest income for tax purposes each year, even though no cash is received. This is governed by original issue discount (OID) rules.
Why are zero-rate bonds more sensitive to interest rate changes?
Because zero-rate bonds have no interim cash flows and all their value is received at maturity, their duration is longer, making them more sensitive to interest rate fluctuations compared to coupon-paying bonds.
