Most bonds pay regular interest. Zero-coupon bonds pay nothing until maturity — then return a lump sum that includes all the "interest" built in. They sound simple, but they're one of the most mathematically elegant and interest-rate-sensitive instruments in all of fixed income.
A zero-coupon bond is issued (or trades) at a significant discount to its face value. At maturity, you receive the full face value. The difference between your purchase price and face value is your entire return — there are no interim coupon payments.
You pay £676 now and receive £1,000 in 10 years. The £324 difference is your total return. Calculated as: £1,000 ÷ (1.04)^10 = £676. This is present value — the foundation of all bond pricing.
Remember duration — the measure of interest rate sensitivity? A zero-coupon bond has the highest possible duration for its maturity, because there are no interim cash flows. Every single pound of return sits at the maturity date. A 20-year zero-coupon bond has a duration of exactly 20 years — a 1% rise in yields causes roughly a 20% fall in price.
This makes zeros extremely volatile in a changing rate environment. A 30-year zero-coupon Treasury can swing 30%+ in price with a single percentage point rate move. They're not for the faint-hearted or for investors who need stability.
STRIPS stands for Separate Trading of Registered Interest and Principal Securities. The US Treasury allows conventional bonds to be "stripped" — their coupon payments and principal separated and sold individually as zero-coupon instruments. A 10-year Treasury has 20 semi-annual coupons plus the final principal repayment — each can be sold as a separate zero-coupon bond. STRIPS are widely used by pension funds and insurance companies to precisely match long-dated liabilities.
The tax trap in the UK: HMRC taxes the "imputed interest" on zero-coupon bonds annually — even though you receive no actual cash until maturity. You pay tax on phantom income each year. This means zeros are most efficiently held inside an ISA or SIPP where the tax treatment is irrelevant. Outside a tax wrapper, the annual phantom income tax drag significantly reduces the after-tax return.
That wraps up the Bonds section. You now understand the full fixed income landscape — from gilt yields and credit ratings to convertibles, inflation protection, and the exotic end of the curve. Next: Crypto.
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