Zero-Coupon Bonds and Treasury STRIPS: Pricing, Duration and Risks

A zero-coupon bond has no periodic coupon payments: its return, if obligations are honoured, comes from the difference between the purchase price and the amount paid at maturity. This concentrated cash-flow structure can suit a defined future liability but makes its market value sensitive to changes in interest rates, particularly at longer maturities.

This guide explains zero-coupon pricing, the Treasury STRIPS mechanism, maturity matching and the risks that remain even when an instrument is held to receive one specified future payment. Tax treatment differs by jurisdiction and must not be inferred from the absence of a cash coupon.

Key takeaways

• A true zero has one contractual payment at maturity rather than a stream of periodic coupons.
• Its value is the present value of that payment under an appropriate yield and compounding convention.
• At a common yield and maturity, a zero’s duration is generally longer than a coupon bond’s duration.
• STRIPS are created from eligible underlying Treasury or gilt securities; the separated claims have individual dates and market prices.

Essential terms and definitions

Face value

The contractual principal amount due at redemption, subject to issuer performance and instrument rules. A purchase below face value does not itself guarantee profit if a holder sells early or the debtor fails to pay.

Discount price

A market price below a stated par amount, often reflecting the time value of a later cash flow. The difference between discount and face value is not an immediately received income stream.

Present value

A future cash amount expressed in current monetary terms by discounting at a specified rate. The selected market discount rate, compounding frequency, credit spread and currency strongly affect the result.

Effective yield

A rate of return computed under a stated compounding convention for the scheduled payment and purchase price. Comparing a simple discount quote with an effective annual yield without converting conventions can be misleading.

Macaulay duration

The cash-flow-weighted average time to receive a bond’s payments under a consistent yield convention. For a conventional fixed-payment zero, Macaulay duration equals time to maturity; modified duration scales interest-rate sensitivity by the relevant yield factor.

STRIPS

Separate Trading of Registered Interest and Principal of Securities; eligible Treasury coupon and principal cash flows can be separated and traded as individual claims. TreasuryDirect says the separated instruments are generally accessed through eligible financial institutions or brokers, not purchased as STRIPS directly in TreasuryDirect.

Coupon strip

A security representing one separated interest cash flow that was originally scheduled on a coupon-bearing government bond. Although sourced from an interest payment, it itself pays only when that stripped component matures.

Principal strip

A security representing the separated final principal cash flow of an eligible underlying bond. It normally has a different maturity and price from the earlier coupon strips created from the same underlying bond.

How it works: mechanisms and financial interpretation

Why a zero is a different cash-flow instrument

A conventional coupon bond returns some cash before final maturity, leaving the investor to decide how to reinvest those payments. A zero instead has one known contractual payment date and amount, assuming no default, indexation adjustment or other special feature. That structure simplifies alignment with a single liability but gives the investor no interim coupons to spend or reinvest. The investor still bears market price movements if the instrument must be sold before maturity.

The basic pricing formula

For a zero paying F at maturity in T years and an effective annual market yield y, the simple teaching formula is P = F ÷ (1+y)^T. The exponent and denominator change with compounding conventions. For a nominal zero paying £1,000 in five years and y = 4%, the price is £1,000 ÷ 1.04^5 ≈ £821.93. The difference of £178.07 accumulates economically over time if the assumed cash flows and yield are realised.

Duration and interest-rate sensitivity

Because a zero provides all its value at one maturity date, its Macaulay duration equals that maturity in years under standard assumptions. A five-year zero therefore has five-year Macaulay duration; its modified duration at a 4% effective annual yield is about 5/1.04 = 4.81 years. That suggests an approximate 4.81% price decline for a one-percentage-point rise in yield, before convexity. The estimate becomes less reliable for large yield moves.

How STRIPS are created

The US Treasury’s STRIPS programme allows eligible fixed-principal securities to have each interest payment and principal repayment separated into distinct tradable zero-coupon components. A ten-year note with semiannual coupons can, if eligible and fully stripped, produce 20 coupon-payment strips and one principal strip. Market participants can reconstitute eligible pieces under the relevant rules. The US Treasury does not directly auction individual STRIPS, and eligibility does not extend to every security type.

UK gilt strips and the tax issue

The UK has a similar concept of separable gilt cash flows, often called gilt strips, with eligibility and handling governed by market arrangements. The HMRC guidance distinguishes the instrument from the original coupon gilt and discusses its treatment as a deeply discounted security. Tax consequences depend on residence, account type, instrument, period and law. A purchaser should not presume that receiving no interim cash makes annual tax obligations impossible.

Single future payment does not mean risk-free

A default-free assumption may simplify rate-risk calculations but is not a universal promise. Sovereign credit exposure, currency denomination, inflation, liquidity and taxes matter. A nominal payment of £1,000 in ten years has uncertain real purchasing power. Long-dated zeros can also fall sharply in market value if yields rise, forcing a seller to crystallise losses even if the issuer ultimately pays in full.

When a maturity match is useful

A single known future liability can be compared with a cash flow due at the same date, removing much of the reinvestment uncertainty associated with intervening coupons. Yet a matching bond must also be assessed for issuer performance, settlement timing, cash currency and sufficient principal. Holding several zeros for several liabilities creates a cash-flow schedule that requires independent verification rather than assuming one ‘portfolio yield’ satisfies every payment.

Worked numerical example

Suppose a zero-coupon security pays £10,000 exactly three years from now and its market yield is an effective annual 5%. The hypothetical price is £10,000 ÷ 1.05³ ≈ £8,638.38. If the market yield immediately rises to 6% with maturity still treated as three years, the corresponding price becomes £10,000 ÷ 1.06³ ≈ £8,396.19, a decline of about 2.80%. If a year passes with no change in the 5% yield and two years remain, the model price becomes £10,000 ÷ 1.05² ≈ £9,070.29; this is the passage-of-time effect under a fixed yield, not a guaranteed realised market gain.

Additional scenario: matching a future liability with a zero

Suppose a fictional organisation must pay £25,000 in exactly four years and is considering a nominal zero-coupon security with a specified payment of £25,000 on that date. At an effective annual market yield of 3.5%, the present value is approximately £25,000 ÷ 1.035⁴ = £21,786.06. The logic of matching is straightforward: a known contractual payment can be aligned with a known liability. However, the arrangement still requires the issuer to perform, the security to settle on the exact day, matching currency and an allowance for any administrative cash expense. The market yield and purchase price may change before the purchase is executed.

If yields rise after purchase, an interim quotation can show a loss without changing the zero’s contractual maturity amount. That distinction matters to an investor who can hold to the scheduled date without needing to sell. For an investor subject to margin calls, valuation rules or unexpected cash needs, a fall in market price may still be economically consequential. Likewise, an inflation-linked liability may not be met by a fixed nominal cash amount whose purchasing power has changed. The word ‘maturity matching’ should never obscure which risks have actually been matched.

STRIPS caution: Eligibility, market access, reconstitution and payment mechanics are specific to the government debt programme. A stripped coupon and stripped principal claim may carry the same sovereign issuer exposure but have different maturities and market prices. US and UK tax guidance for such securities should be checked separately against the holder’s circumstances. An investor should not automatically transplant US STRIPS tax language to gilt strips or conclude that the absence of interim cash means the absence of potentially taxable accrual.

Comparison table

Professional research checklist

A rigorous fixed-income analysis begins by separating contractual cash-flow rights from market scenarios. Use the exact security terms, quote convention, settlement date and relevant benchmark. Specify which cash flows are certain under the contract, which depend on issuer performance, and which are estimated from models or expectations. A headline yield or familiar label cannot replace this work.

1. Use the exact maturity date and quote convention, not just the rounded term in years.
2. Distinguish issuer maturity payment from current market resale value.
3. For tax analysis, identify the purchaser’s jurisdiction and account context rather than relying on a generic example.
4. Check that the desired future liability has the same currency, settlement day and sufficient payable amount.

Document the source and date of inputs, test an adverse scenario and distinguish held-to-maturity assumptions from a possible early sale. Transaction costs, spreads, taxes, currency conversion and the availability of cash or collateral can change realised results. Avoid treating one favourable historical episode as an assurance that the same relationship will recur.

Frequently asked questions

Is a zero-coupon bond the same as a Treasury bill?

Both may provide a single maturity payment, but Treasury bills have different issuance conventions and maturity ranges; STRIPS are separate claims created from eligible longer-term securities.

Why are long zeros especially rate-sensitive?

Most of their value represents one distant payment, so a change in discount rates compounds over the entire remaining term.

Can a STRIP be sold before it matures?

Eligible STRIPS are tradeable through market intermediaries, but the sale price depends on prevailing rates and market liquidity and can be below the purchase price.

Continue learning

Bond Prices and Yields; Bond Immunisation; Government Bonds and Gilts. Explore the Bonds & Fixed Income category or the Education Hub.

Authoritative sources and further reading

• TreasuryDirect: STRIPS
• HMRC: Gilt strips

Important notice: General financial education only. This article does not provide personalised investment advice or a recommendation to buy, sell or hold a security. All numerical scenarios are hypothetical. Bonds and derivatives can involve credit, interest-rate, inflation, liquidity and other risks, including loss of capital.