Zero-Coupon Bond [STRIPS]

Zero-coupon bonds pay no periodic interest, instead being sold at a deep discount to face value with the full face amount paid at maturity. The return comes entirely from price appreciation. For example, a 10-year zero with $1,000 face value might sell for $610, providing a 5% annual return through the $390 gain. Zeros are created either as original issues (like Treasury STRIPS) or by stripping coupons from regular bonds. They offer advantages including no reinvestment risk (since there are no coupons to reinvest), precise cash flow timing for liability matching, and potentially favorable tax treatment in certain accounts. However, they have high duration risk – a 30-year zero’s price might change 30% for a 1% rate change. Despite paying no cash interest, investors owe taxes annually on imputed interest (phantom income), making them popular for tax-deferred accounts. Common users include pension funds matching long-term liabilities and investors seeking specific future cash flows.