How can a zero-coupon bond be useful in funding a future liability, and what specific risks should be considered when doing so?

A zero-coupon bond can be useful in funding a future liability because it provides a known, guaranteed lump-sum payment at a specific maturity date, aligning perfectly with the timing and amount of a future financial obligation. Since it doesn't pay periodic interest, its entire return comes from the difference between the purchase price and the face value received at maturity. This eliminates reinvestment risk, the risk that interest payments cannot be reinvested at the same rate of return. However, specific risks must be considered. Interest rate risk is significant because the bond's price is highly sensitive to interest rate changes; if interest rates rise, the bond's value could decrease substantially before maturity. Inflation risk is another concern, as the purchasing power of the future payment could be eroded by inflation. Furthermore, zero-coupon bonds are typically more volatile than coupon-paying bonds of the same maturity because they have a longer duration. Credit risk is present if the issuer defaults, resulting in non-payment of the face value. Additionally, the accrued interest on zero-coupon bonds is taxable annually, even though no cash is received, which could create a tax liability. Therefore, zero-coupon bonds are best suited for tax-advantaged accounts where the accrued interest is not taxed annually.