A zero-coupon bond is a debt security that does not pay periodic interest (coupon) payments. Instead, it is issued at a deep discount to its face value and pays the full face value at maturity. The difference between the purchase price and the face value represents the investor's return. These bonds are also known as discount bonds or deep discount bonds.

Zero-coupon bonds are issued by governments, corporations, and municipalities. U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal Securities) are among the most well-known zero-coupon bonds. Because there are no periodic payments, investors know exactly how much they will receive at maturity, making these bonds popular for future financial planning such as funding education or retirement.

The price of a zero-coupon bond is determined by discounting the face value back to the present using the yield to maturity (YTM). For example, a $1,000 face value bond with a 5% YTM and 10 years to maturity would be priced at approximately $613.91. As the bond approaches maturity, its price gradually increases toward the face value, a process known as accretion.

The yield to maturity can be calculated from the current market price by rearranging the pricing formula. This gives investors a way to compare returns across different bonds with varying maturities and prices. The YTM represents the annualized return an investor will earn if they hold the bond until maturity.

Zero-coupon bonds are particularly sensitive to interest rate changes due to their long duration. When interest rates rise, the price of a zero-coupon bond falls more sharply than a comparable coupon-paying bond. This makes them riskier in a rising rate environment but potentially more rewarding when rates decline.

Another important consideration is taxation. In many jurisdictions, the imputed interest (phantom income) on zero-coupon bonds is taxable annually even though no cash is received until maturity. This makes them particularly well-suited for tax-advantaged accounts like IRAs or 401(k)s where the phantom income tax issue is eliminated.

Zero-coupon bonds are ideal for investors with a specific future financial goal, such as funding a child's college education or planning for retirement. Because the maturity value is known in advance, investors can precisely match their investment to their future cash need. This makes zero-coupon bonds excellent tools for liability matching and immunization strategies.

They are also attractive when interest rates are expected to decline, as falling rates cause bond prices to rise. Investors seeking capital appreciation rather than current income may prefer zero-coupon bonds for this reason. However, investors should carefully consider the credit quality of the issuer, the time horizon, and the interest rate environment before investing.