Financial Markets For The Rest Of Us|
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
and are redeemed at their face values at maturity. These are not unlike short-term government bonds such as T-bills with maturity dates between 3 months to 1 year which are sold at a discount.
Let's take a closer look at how zero coupon bonds work. Take the 30- year long bond as an example. If you bought $10,000 worth of the long bond at 6% interest rate with interest payments every 6 months you would have 60 interest payments of $300 each:
30 years x 2 payments per year = 60 payments $10,000 x 6% = $600 per year = $300 per 6 months
And at the end of 30 years, which is the maturity date, you are due your original principal of $10,000. This makes for 61 components for the long bond.
Now under the Treasury Department's STRIPS (Separate Trading of Registered Interest and Principal of Securities) program, the long bond can be stripped into 61 separate components and sold as separate securities each with its own CUSIP (described below) number. For example, the principal component of $10,000 can now be sold separately from the 43rd interest payment of $300. Of course the $10,000 zero coupon bond maturing in 30 years is now sold at a discount. The discount price is determined by taking into consideration the compound interest and the maturity length.
For example the same $10,000 zero coupon bond maturing in 30 years with the compounded interest of 6% would be sold at approximately $1,741 excluding commission charges. (Look at it this way: if you invested $1,741 in an account paying 6% compounded interest, you would have $10,000 in 30 years. Hence the $10,000 zero coupon can be sold at $1,741 today based on a 6% compounding over …
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