zero coupon bonds and strips

In short

A friend of mine once bought a savings bond for his grandson and called it the slowest gift he ever gave. He was right, and he was proud of it. A zero coupon bond works in much the same way. It pays no interest along the way, and it pays one lump sum on a set date. The buyer pays less than face value, and the gap between the two prices is the return. A STRIPS is a Treasury security that has been split into pieces like this. Held in a regular account, it can leave the owner owing tax each year on interest not yet received. Its price swings more than a regular bond when rates move. The yield to maturity is the fair way to compare any two of them.

The whole of it

What it is

I once watched a neighbor pay for a used truck in a single check, and the seller handed over the keys that same afternoon. No monthly bills, no interest line. A zero coupon bond has that same one and done feel, only the check goes the other direction. The buyer pays a small amount now, and the issuer pays a larger amount later.

A friend of mine likes to say every bond has two prices, and he is right. The face value is the amount paid back on the maturity date. The purchase price is always lower. Say a bond promises $1,000 in ten years. A buyer might pay $700 today. The $300 difference is the earnings.

A regular bond is different. It sends out small interest payments, called coupons, every six months or so. A zero coupon bond skips those. That is where the name comes from.

Now for the word STRIPS. It stands for Separate Trading of Registered Interest and Principal of Securities. I once watched a man take a clock apart on his kitchen table, and banks and brokers do much the same with a Treasury note or bond. The Treasury does not sell these straight to the public in the usual way. Instead, banks and brokers pull a regular Treasury note or bond apart. Each coupon payment becomes its own piece. The final principal payment becomes another piece. Each piece then trades by itself as a zero coupon security. TreasuryDirect, the Treasury's own site, explains this process, and it is worth a look.

Zero coupon bonds also come from other issuers. Corporations sell them. So do cities and states. Their risk depends on who is doing the borrowing. A STRIPS carries the backing of the U.S. government, since it comes from Treasury securities.

How it works

If you are holding a regular bond, you can see your money arrive in small pieces. With a zero coupon bond, nothing arrives until the end. So how does the price move up over time? It climbs a little each day. The bond is said to accrete, which just means it grows toward face value as the maturity date gets closer.

The price paid depends on two things. One is how long the wait is. The other is the yield, the yearly rate of return the market wants right now. A longer wait and a higher yield both push today's price down. A shorter wait and a lower yield push it up.

This also explains why prices swing so much. A bond that pays everything at year thirty has all its value stacked at the far end. When market rates shift, that far off payment gets repriced hard. A coupon bond hands back some cash early, so it moves less. A zero coupon bond cannot do that. Fans of the product know this, and critics point to it. Both are right.

Then there is the tax side. This catches people off guard. The IRS treats the yearly growth in a zero coupon bond as interest, even though no cash shows up. That growth is called original issue discount, and Publication 550 from the IRS covers how it works. In a taxable account, the owner may owe tax each year on money not yet received. Many people hold these inside a retirement account for that reason. Inside an IRA, the yearly tax bill does not appear.

The numbers, and where to find yours

You have probably wondered what a fair price looks like. The math is plain. Take the face value and divide by one plus the yield, raised to the number of years. Your broker shows the real yield on the trade screen, and TreasuryDirect and the Treasury's daily yield data show current market rates.

Some figures change year to year. The yearly limit for IRA contributions is $7,500 for 2026 (source, checked 10/4/2026). The amount a worker can put in a 401(k) is the current figure, which the official source publishes each year. These matter for anyone who plans to hold a zero coupon bond inside a retirement account. The site fills in the verified figure with its source and date.

The ordinary income tax bracket a person lands in sets how much the yearly phantom interest costs. The bracket can be found in the IRS tax tables. The IRS also lists the yearly interest amounts on Form 1099 OID, which the broker sends. That form is the first place to check each spring.

Fees and markups matter too. A bond sold at a thin spread costs less than one with a fat markup. A broker can show the price and the yield side by side. Those figures can then be checked against the Treasury's own data.

A worked example

A woman I know named Carla is forty five. She wants a set amount of cash on the day her daughter starts college, which is ten years away. She finds a zero coupon bond with a face value of $10,000 and a yield of 4 percent a year.

The price today is the face value divided by one plus the yield, raised to the tenth power. First, 1.04 raised to the tenth power is about 1.4802. Then $10,000 divided by 1.4802 is about $6,756. So Carla pays about $6,756 today.

Her earnings are the face value minus the price. That is $10,000 minus $6,756, which is $3,244. She gets that whole amount at year ten, not before.

Now the tax part. If Carla holds this in a taxable account, she reports the yearly growth. In year one, the growth is about 4 percent of $6,756, which is $270. If her tax rate is 22 percent, that is about $59 owed on $270 she has not touched. Over ten years the yearly growth gets larger, so the tax bill rises too. Carla decides this is a lot of out of pocket cost for cash she cannot spend, so she holds the bond in an IRA instead. There, no yearly bill appears.

She also checks the rate risk. Suppose market yields jump to 6 percent a year later, and her bond has nine years left. Its price becomes $10,000 divided by 1.06 raised to the ninth power. That is $10,000 divided by 1.6895, or about $5,919. The price a year earlier would have been $10,000 divided by 1.04 raised to the ninth power. That is $10,000 divided by 1.4233, or about $7,026. Her paper value fell from about $7,026 to $5,919. That is a drop of $1,107. If she sells then, she takes the loss. If she holds to year ten, she still gets $10,000. Carla chooses to hold, but she knows the price will bounce along the way.

Where it goes wrong

Nobody likes a surprise bill, and the yearly tax on a bond with no cash is the biggest one. A person who skips this detail may owe tax with no cash on hand to pay it. That is a bad spot.

The second trouble is selling early. A zero coupon bond that gets sold before maturity trades at the going market price. That price may be well below what the owner paid. Rates rise, and the price falls. Simple as that.

Third, buyers sometimes mix up the yield and the face value. A bond with a high face value is not a bargain just because the number looks big. The price paid and the time held set the real return. Yields, not face values, give the fair comparison.

Fourth, a corporate or city zero coupon bond carries credit risk. The borrower has to repay, and some borrowers do not. A STRIPS has the Treasury behind it. Other issuers do not.

Finally, many zero coupon bonds can be called, meaning the issuer may pay them off early. A call can end the bond sooner than planned. The terms of the bond say whether a call is allowed.

Questions to answer before you leave this page

What date do you need the money, and does the bond mature on or near that date? Will the bond sit in a taxable account, where yearly tax may come due on interest you have not received, or inside a retirement account? Is the money safe to leave alone until maturity, given that a bond sold sooner trades at whatever the market price turns out to be? Who stands behind the payment, the U.S. Treasury or a company or city that could fail to repay? Does the bond have a call feature that lets the issuer pay it off early? What yield does your broker show, and does it match the current rates posted on TreasuryDirect? And have you looked at what the markup costs, so that you know the real price you are paying?