Zero-coupon bonds do not make periodic interest payments. Instead, they are issued at a deep discount to face value and mature at par. The annualized return is determined by the discount at purchase:
Where is face value, is purchase price, and is years to maturity. While zero-coupon bonds eliminate reinvestment risk (since there are no coupon payments to reinvest in a potentially falling rate environment), they suffer from extreme interest rate sensitivity due to their high duration.
Furthermore, they carry a significant tax friction: the IRS requires you to report and pay tax on the imputed interest annually as ordinary income under the OID rules of IRC §1272. This “phantom income” is calculated using the constant-yield accretion method based on the Afr under IRC §1274. Because of this annual tax liability without corresponding cash flow, zero-coupon bonds should be held exclusively in tax-advantaged accounts like IRAs.
STRIPS (Separate Trading of Registered Interest and Principal of Securities) Treasury STRIPSs are created by financial institutions or government securities dealers who separate the interest coupon payments from the principal payment of a nominal Treasury note or bond. Each individual component becomes a distinct zero-coupon security backed by the U.S. government.
Because a long-term STRIPS has no intermediate cash flows, its duration is exactly equal to its maturity (e.g., a 25-year STRIPS has a duration of 25 years, compared to roughly 6.6 years for the Bloomberg U.S. Aggregate Bond Index). This massive duration concentration makes STRIPS a highly capital-efficient tool: you can establish significant interest-rate risk exposure (to hedge a liability or an equity-heavy portfolio) using a small fraction of your portfolio’s capital.