Investments, tenth edition

  Zero-Coupon Bonds and Treasury Strips 

  Original-issue discount bonds  are less common than coupon bonds issued at par. These are 

bonds that are issued intentionally with low coupon rates that cause the bond to sell at a dis-

count from par value. The most common example of this type of bond is the  zero-coupon 

bond,  which carries no coupons and provides all its return in the form of price appreciation. 

Zeros provide only one cash flow to their owners, on the maturity date of the bond. 

 U.S. Treasury bills are examples of short-term zero-coupon instruments. If the bill has 

face value of $10,000, the Treasury issues or sells it for some amount less than $10,000, 

agreeing to repay $10,000 at maturity. All of the investor’s return comes in the form of 

price appreciation. 

 Longer-term zero-coupon bonds are commonly created from coupon-bearing notes and 

bonds. A bond dealer who purchases a Treasury coupon bond may ask the Treasury to break 

down the cash flows to be paid by the bond into a series of independent securities, where 

each security is a claim to one of the payments of the original bond. For example, a 10-year 

coupon bond would be “stripped” of its 20 semiannual coupons, and each coupon payment 

would be treated as a stand-alone zero-coupon bond. The maturities of these bonds would 

thus range from 6 months to 10 years. The final payment of principal would be treated as 

another stand-alone zero-coupon security. Each of the payments is now treated as an inde-

pendent security and is assigned its own CUSIP number (by the Committee on Uniform 

Securities Identification Procedures), the security identifier that allows for electronic trad-

ing over the Fedwire system, a network that connects all Federal Reserve banks and their 

 Show that if yield to maturity increases, then holding-period return is  less  than initial yield. For example, 

suppose in Example 14.9 that by the end of the first year, the bond’s yield to maturity is 8.5%. Find the 

1-year holding-period return and compare it to the bond’s initial 8% yield to maturity. 

 CONCEPT CHECK 

14.6 

 Consider a 30-year bond paying an annual coupon of $80 and selling at par value of 

$1,000. The bond’s initial yield to maturity is 8%. If the yield remains at 8% over the 

year, the bond price will remain at par, so the holding-period return also will be 8%. But 

if the yield falls below 8%, the bond price will increase. Suppose the yield falls and the 

price increases to $1,050. Then the holding-period return is greater than 8%:   

Holding-period return

5

$80

1 ($1,050 2 $1,000)

$1,000

5 .13, or 13%