Think: trading marbles in the playground. Only, instead of marbles, it's streams of interest payments (usually) on bonds that are being exchanged. One is a rate that floats, in this flavor...and another, usually, comprises a one-time payment whose discounted cash value equals the sum total, risk adjusted, of those streams of coupons being paid out until maturity.
See: Zero Coupon Bonds for the financial model, but the notion is that in anything that's a zero coupon something, no interest payments are made until an end date, at which point both the principal and the sum total of all of those coupons are paid in one swell foop.
In this case, there's just a swap happening for the stream of payments against that one-timer.
Related or Semi-related Video
Finance: What are the tax implications o...0 Views
Finance allah shmoop What are the tax implications of zero
coupon bonds All right well from the investors side you
think that a zero coupon bond would simply have attacks
being paid when the bond and interest payments fully mature
a goal that we hear it shmoop clearly have not
yet achieved That is you buy a zero for half
or two thirds or three force of its par value
and something like that You get no interest or any
payments of any kind along the way for years But
then at the end you get par like three thousand
box or whatever amount of the zero yabba like you
spent two grand and it matures and pars three grand
cause he had three bonds and then you're done well
At that point you pay a tax right and you
think it might be assessed as a long term game
kind of tax because you bought and held it over
a year just like you would have you bought in
equity and held it on five six seven years and
then sold it some gain At that point in an
equity you'd be taxed the long term gains cheaper tax
treatment iaea You know when you sold and turned into
cash but oh so not the case with zero coupon
bonds instead with zero coupon bonds taxes are paid on
the annual imputed maturity of the bond itself such that
if you paid say five hundred bucks for a zero
coupon bond matures with all payments included at a thousand
dollars five years later well you'd be paying tax on
an imputed gain of one hundred bucks a year which
would comprise basically a bundled gain of notional principal gagne
plus whatever imputed interest was included in the bond And
that is tax as ordinary income not long term game
that is you pay the higher tax rate because well
it's a bond and its interest on the bonds you're
paying on so things air re calculated annually And that
hurts So you don't really own anything for more than
a year before uncle sam comes by tio you know
pick your pocket You actually lose cash along the way
with zero coupon bonds and then get a whole bunch
Each of it vomited back to you at the end
On top of everything zeroes are riskier than normal bonds
because they pay nothing along the way and well all
bets iran that they eventually pay off fully at the
end But you know you never know So given everything
you'd better be sure you're getting a big premium for
buying a zero coupon bond over a normal one If
you do some day you want to go in this 00:02:19.8 --> [endTime] direction you know putting your nuts to work
Up Next
What is a zero coupon bond? Zero coupon bonds are an interesting investment because they don’t pay any interest. They are only desirable because...