Zero-Coupon Bonds and STRIPS

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 $F$ is face value, $P$ is purchase price, and $n$ 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: you must report and pay tax on the imputed interest annually as ordinary income under the OID rules of IRC §1272, “Current inclusion in income of original issue discount”. This “phantom income” accretes under the constant-yield method of IRC §1272(a)(3), using the bond’s own yield to maturity at the time you acquired it — not the Afr, which governs imputed interest on debt issued for property under IRC §1274 and has nothing to do with accreting a Treasury strip. Because of this annual tax liability without corresponding cash flow, hold zero-coupon bonds 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 Macaulay duration equals its maturity exactly — a 25-year STRIPS has a Macaulay duration of 25 years, against roughly 6.6 years for the Bloomberg U.S. Aggregate Bond Index. The modified duration that actually predicts the price move is slightly lower, $\text{MacD}∕(1+y∕m)$ per the formula above, so at a 4.5% semiannual yield that 25-year strip carries a modified duration near 24.5. 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.