Zero-Coupon Bonds and STRIPS

Why this matters

Zero-coupon bonds have appeared at the edge of every lesson in this module: the bond whose duration equals its maturity, the bond with no reinvestment risk, the spot rate that discounts a single payment. They're also real things you can buy. They're the simplest bond there is, one payment on one date, and that simplicity gives them properties no coupon bond has, some useful and some uncomfortable. The tax rules described here are US rules.

One payment, one price

A zero-coupon bond pays no interest along the way. You buy it at a discount from its face value and receive the face amount when it matures.¹ Its price is a single present value, using the same half-year convention as other bonds.

Price = Face value ÷ (1 + Yield ÷ 2) raised to the number of half-years

Maturity	Sum	Price today
5 years	$1,000 ÷ 1.02510	$781.20
10 years	$1,000 ÷ 1.02520	$610.27
20 years	$1,000 ÷ 1.02540	$372.43
30 years	$1,000 ÷ 1.02560	$227.28

The longer the wait, the deeper the discount. FINRA's own illustration is of the same kind: a 20-year zero with a face value of $10,000 bought for $3,500,¹ which works out to a yield of about 5.3%.

Between purchase and maturity, the bond's value climbs toward $1,000. If its yield never changed, the path would be smooth, each half-year adding 2.5% to the value before.

End of year	Value	Growth during the year
At purchase	$610.27
1	$641.17	$30.89
2	$673.62	$32.46
5	$781.20	$37.64
9	$951.81	$45.86
10	$1,000.00	$48.19

The growth is the bond's interest. Nothing is paid out, so it compounds inside the price, and the dollar amount rises each year. That yearly growth matters again in the section on tax.

Where zeros come from

Federal agencies, municipalities, financial institutions, and corporations issue zero-coupon bonds.¹ The best-known zeros aren't issued at all. They're made from ordinary Treasuries, and they're called STRIPS, for Separate Trading of Registered Interest and Principal of Securities.

The idea is that a note or bond is a bundle of payments, and the bundle can be untied. A bond with ten years left consists of twenty interest payments and one principal payment. When it's stripped, each of the twenty-one becomes a separate security that can be bought and sold on its own. Treasury notes, bonds, and TIPS can be stripped, and bills and floating rate notes can't. A dealer that collects all the remaining pieces can also reassemble the original security.²

$1,000 of a note with a 5% coupon, when the yield for every maturity is 5%.

Piece	Pays	Value today
First interest payment, in 6 months	$25	$24.39
Last interest payment, in 10 years	$25	$15.26
All twenty interest payments together	$500	$389.73
The principal payment, in 10 years	$1,000	$610.27
The whole note	$1,500	$1,000.00

The pieces add up to the whole. In a real market each piece is valued at the spot rate for its own date, as in The Yield Curve in Depth, and the ability to strip and reassemble helps keep the sum of the parts close to the price of the bond.

Stripping happens in the system that banks, brokers, and dealers use to hold Treasuries, and it can't be done in a TreasuryDirect account, so an individual buys STRIPS through a broker.²

The rest of this lesson is for members

Still to come in this lesson: What a zero does well, What a zero does badly, Tax on interest you haven't received, the key takeaways, and 2 quiz questions with explanations.

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