Zero-Coupon Bonds: How They Work and When to Use Them

Zero-coupon bonds are fixed-income instruments that differ from conventional bonds in one fundamental respect: they pay no periodic interest. Instead, they are issued at a deep discount to their face (par) value and mature at par. The investor's entire return comes from the difference between the purchase price and the maturity value, accumulated over the life of the bond.

Despite their apparent simplicity, zero-coupon bonds have specific characteristics — particularly around duration and tax treatment — that make them particularly useful for certain portfolio strategies and potentially disadvantageous in others.

This guide is for general information purposes only and does not constitute investment advice. All bonds carry risk, including interest rate risk, credit risk, and, for non-UK bonds, currency risk. Seek independent professional financial advice before investing.

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How Zero-Coupon Bonds Work

Basic Mechanics

A zero-coupon bond with a face value of £100,000 maturing in 10 years and priced to yield 4% per annum will trade at approximately:

£100,000 ÷ (1.04)^10 = £67,556

The investor pays £67,556 today and receives £100,000 in 10 years. No interest payments are made in between. The return is entirely capital gain: £32,444 over 10 years, which equates to a compound annual return of 4%.

The discount is larger:

• The longer the maturity (longer period over which interest compounds)
• The higher the yield (more discounting per period)

A 20-year zero at 4% would price at approximately £45,639 (the investor nearly doubles their money, all as capital appreciation). A 30-year zero at 4% prices at approximately £30,832.

Where They Come From

Zero-coupon bonds arise in two main ways:

1. Direct issue: Some governments and corporations issue zero-coupon bonds specifically — sold at a discount and redeemed at par, with no periodic coupon. Some infrastructure bonds and project finance vehicles are structured as zeros. (Note that not every "no-income-until-maturity" instrument is a true zero-coupon bond: US Savings Bonds, for example, are accrual bonds sold at face value that earn and compound interest internally rather than being issued at a deep discount.)

2. Strips: Investment banks and primary dealers "strip" conventional coupon bonds into their component cash flows. Each coupon payment and the final principal repayment become separate zero-coupon instruments. UK gilt strips are the most important domestic example — they are created by stripping UK government gilts and are actively traded in the wholesale market. US Treasury STRIPS are the equivalent in the US market.

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Duration: The Key Characteristic

The most distinctive feature of zero-coupon bonds from a portfolio management perspective is their duration.

Duration measures the sensitivity of a bond's price to changes in interest rates. For a conventional coupon bond, duration is always less than the bond's maturity because some cash flows (coupons) are received before maturity. For a zero-coupon bond, all cash flow is received at maturity, so the duration equals the maturity exactly.

This has profound implications:

Zeros are the most interest-rate-sensitive instruments available. A 20-year zero has a duration of 20 years. If yields rise by 1%, the price of the zero falls by approximately 20%. A 20-year conventional gilt with regular coupons has a duration of around 14–16 years — the same yield rise causes a smaller price fall.

This makes zero-coupon bonds:

• Highly effective for liability-driven investment: If you need to match a specific future liability, a zero-coupon bond maturing on that date at the required amount is the cleanest possible match. No reinvestment risk (no coupons to reinvest at uncertain future rates). Perfect liability matching.

• Highly risky in a rising rate environment: If held speculatively, a 30-year zero-coupon bond will suffer catastrophic capital losses if yields rise significantly before maturity. An investor who bought 30-year zeros in 2020 at yields of 0.5–1% and held them to 2022 saw prices fall 50–70% as yields normalised.

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Tax Treatment in the UK

The UK tax treatment of zero-coupon bonds is critically important and is one reason they are often held inside tax wrappers:

Deeply Discounted Securities (DDS)

HMRC treats zero-coupon bonds (and other bonds issued at a significant discount to face value) as "deeply discounted securities" (DDS). Under DDS rules, the annual accrual of the discount — the economic interest income — is treated as income, not capital gain, for UK income tax purposes.

This means:

• Even though no cash is received, income tax is payable annually on the accrued discount
• The income is subject to income tax at the investor's marginal rate (up to 45% for additional rate taxpayers)
• This can create a cashflow problem: tax is payable annually but cash is not received until maturity

Implications

For a UK taxpayer holding zeros outside a tax wrapper, the income tax treatment significantly reduces the attractiveness. An additional-rate taxpayer earning a 4% gross yield on a zero may pay 45% income tax annually on the accruing discount, reducing the net return substantially.

Within a SIPP or ISA, zero-coupon bonds are highly attractive. No income tax is payable on the annual accrual, and the full gross return is captured. Long-dated zero-coupon gilts within a SIPP are an extremely tax-efficient vehicle for locking in long-term compound returns.

For offshore bonds and international investors: Tax treatment varies by jurisdiction. Many offshore jurisdictions apply capital gains tax rather than income tax to zero-coupon bond accretions, or have territorial tax rules that exempt international bond gains. Always take jurisdiction-specific tax advice before investing.

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UK Gilt Strips

Gilt strips are the most accessible zero-coupon instrument for UK-based investors. They are created by the Debt Management Office and traded in the gilt repo market by primary dealers. Retail access is typically via a stockbroker that provides access to the gilt market.

Gilt strips are:

• Backed by the credit of the UK government (extremely high credit quality)
• Available at a wide range of maturities (reflecting the underlying conventional gilt maturities, typically 2–50 years)
• Liquid in the wholesale market (though less so than conventional gilts)
• Available in minimum transaction sizes typically of £10,000 face value

The UK index-linked gilt strip market is smaller, but some linkers exist in stripped form, allowing investors to lock in a real yield on a zero-coupon basis.

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Uses in Portfolio Construction

Liability Matching

As noted above, zero-coupon bonds are ideal for liability matching. Defined benefit pension schemes have historically used gilt strips extensively to match specific pension payment cashflows — funding a known payment in year 12 with a 12-year strip, a payment in year 18 with an 18-year strip, and so on.

Individual investors can use the same approach for specific known future liabilities: a school fees endowment, a property purchase, a business commitment.

Interest Rate Expression

Investors with a strong view that long-term yields will fall significantly can use long-dated zero-coupon bonds as a leveraged expression of that view. Because of the high duration, a 2% fall in long yields could produce a 40% capital gain on a 20-year zero (at constant yield, a duration-20 bond gains approximately 20% per 1% yield fall). This is a high-conviction, high-risk trade.

Deflation Hedge

Zero-coupon bonds perform extremely well in deflationary recessions, where yields fall and the price of long-dated zeros rises sharply. Japan's experience (1990–2015) saw long-dated Japanese government bond zeros deliver strong returns in JPY terms as yields collapsed. Some investors hold a small zero-coupon bond position as a tail-risk hedge against a deflationary scenario.

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Risks

Interest rate risk: As discussed, zeros have the highest duration of any bond instrument. This is a double-edged sword.

Reinvestment risk (not applicable): One advantage of zeros over coupon bonds is the complete absence of reinvestment risk — there are no coupons to reinvest at uncertain future rates. The yield is locked in at purchase.

Credit risk: For corporate zeros, credit risk applies as with any corporate bond. UK gilt strips have negligible credit risk.

Liquidity risk: The secondary market for zeros, while reasonable for gilt strips, is less liquid than for conventional gilts. Wide bid-ask spreads may apply for smaller transactions.

Tax risk: Rules change. The DDS tax treatment could theoretically be modified by HMRC. Investors relying on specific tax wrappers should monitor relevant legislation.

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How Global Investments Can Help

Global Investments works with internationally mobile HNW clients on fixed-income portfolio construction, including the use of zero-coupon instruments for liability matching, long-term compounding, and interest rate risk management. We can help you assess whether zero-coupon bonds are appropriate for your specific objectives — taking into account your domicile, tax wrapper structure, and investment horizon — and identify the most suitable instruments, from UK gilt strips to internationally issued corporate zeros and structured zero-coupon notes.