Zero-coupon bonds make no periodic interest payments. Instead, they are issued at a deep discount to face value and mature at par, with the difference representing the investor's total return. Common examples include Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities), zero-coupon corporate bonds, and zero-coupon municipal bonds. Treasury STRIPS are created when dealers strip the coupons from Treasury notes or bonds and sell each cash flow separately.
The price of a zero-coupon bond is the present value of the par amount discounted at the yield to maturity: Price = Par / (1 + r)^n. Because there are no reinvestment cash flows, zero-coupon bonds have no reinvestment risk and their duration equals their maturity — making them the most interest-rate-sensitive bonds for a given maturity.
The major tax drawback is phantom income (OID — Original Issue Discount). The IRS requires investors holding zero-coupon corporate or Treasury bonds in taxable accounts to accrete the discount annually and recognize it as ordinary income, even though no cash is received. For municipal zero-coupon bonds in taxable accounts, the accretion is tax-exempt at the federal level.
Zero-coupon bonds are excellent tools for asset-liability matching — an investor who needs exactly $100,000 in 18 years can buy zero-coupon bonds maturing on that date and face no reinvestment risk.
> Exam tip: On the Series 7 and Series 65/66, know that zero-coupon bonds have the highest duration (equal to maturity) among bonds with the same maturity — they are the most price-volatile. Remember the phantom income/OID rule for taxable accounts. Municipal zeros avoid phantom income tax; corporate and Treasury zeros do not.