Zero-coupon bonds are bondss which do not pay interest payments (also known as coupon payments). The holder of a zero coupon bond is entitled to receive a single payment, usually of a specified sum of money at a specified time in the future. Some zero coupon bonds are inflation indexed, and so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money.

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.

Strip bonds

Dealers may separate the coupons from the bond principal, which is also known as the residue, so that different investors are entitled to the principal and each of the coupon payments. Both the coupons and residue may be sold to investors. Each of these investments then pays a single lump sum, so it is effectively a zero coupon bond. This method of creating zero coupon bonds is known as stripping and the contracts are known as strip bonds.

Dealers normally purchase a block of high-quality and non-callable bonds - often government issues - to create strip bonds. A strip bond has no reinvestment risk because the payment to the investor only occurs at maturity. There is no guarantee the coupon payments on a regular bond can be reinvested at the same or better yield.

The impact of interest-rate fluctuations on strip bonds is more pronounced than a bond that has both coupons and residue - particularly when the term to maturity is long. Strip bonds are available from investment dealers maturing at terms even up to 30 years.