A zero-coupon bond pays no interest during its life — you buy it cheap and get full face value at maturity. Example: buy a 10-year zero-coupon bond for $600 today and receive $1,000 at maturity. The $400 difference is your return. No coupon checks, no reinvestment decisions — just one lump sum at the end.
The price of a zero-coupon bond is the present value of its face value, discounted at the prevailing interest rate. If rates are 5%, a 10-year zero-coupon bond with $1,000 face value is worth about $614 today. These bonds are extremely sensitive to interest rate changes — a small rate move causes a large price swing because all cash flow is at maturity.
US Treasury STRIPS are the most well-known zero-coupon bonds. In India, the RBI issues zero-coupon bonds for specific purposes. A key tax quirk: even though you receive no cash until maturity, you may owe annual taxes on "phantom income" — the imputed interest accruing each year. Zero-coupon bonds are popular for planning specific future expenses like college tuition.