Investing in strip bonds (part 1)

Investors have been buying and selling bonds for centuries. While equity trading gets more attention and can seem more exciting, bond portfolios don't have to be hum drum. Consider strip bonds — also known as stripped bonds, strips, or zero coupon bonds. These popular fixed-income notes are bought and sold at a discount to their face value.

Strip bonds are an attractive alternative to conventional bonds. This article reviews the key features and benefits of investing in strip bonds.

Conventional bonds have two parts: the face value, or principal, and the coupons. The strip bond is a hybrid fixed income investment created when a standard bond is deconstructed.

For example, ABC Company issues a $100 million bond on June 1, 2016 with a maturity in 20 years — that's the principal. It has an interest rate of 5.00% paid semi-annually on June 1 and December 1 — the coupons. The purchaser of the bond receives a semi-annual coupon in the amount of $2.5 million:

$100MM x 5.00% / 2

On the maturity date of June 1, 2036, ABC Company will pay the last coupon payment of $2.5 million and the principal amount borrowed, $100 million, to the purchaser.

A strip bond is created when the coupons are separated — stripped — from the principal, and the future cash flow payments are sold at a discount and mature at par, similar to a T-bill. When the coupon is separated and sold, it is also called a strip coupon. After the coupons are separated, the remaining bond principal is called a "residual" and this is also sold at a discount and matures at face value.

Looking at the ABC Company 20-year bond mentioned above, it provides 40 coupon payments of $2.5 million, payable on June 1 and December 1 each year until June 1, 2036. The coupon payments can be stripped from the bond's principal, and each individual coupon can be sold at a discount and will mature at face value. The discounted price is based on the current prevailing market yield for the term held until the coupon is paid.

Definitions

Par value: The stated value of a bond, also called "face value" or "maturity value"; the amount that the issuer will pay to the holder when the instrument is redeemed at maturity. The market price of a conventional bond fluctuates, depending on the prevailing interest rates in the economy compared to the bond's coupon rates. A bond price can be at, below or above par. A bond with a 3% coupon will trade at par if interest rates are at 3%, below par if interest rates are at 4%, and above par if interest rates are at 2%. A bond that is trading above par is said to be trading at a premium, while a bond trading below par is referred to as trading at a discount.

Strip bond example

One of the ABC Company coupon payments of $2.5 million is payable on December 1, 2026. If you buy it on December 1, 2016 there are ten years until the maturity of this specific coupon payment. If the prevailing interest rate at that time for this particular issuer for a ten-year bond is 3.5%, the present value of the strip coupon will be 70.87:

PV = 100 / (1 + 3.50%)^10

This means for each dollar, the purchase price will be $0.7087. So the $2.5 million coupon will have a purchase price of $1,771,750 on December 1, 2016. There will be no interest payments, only the maturity of the coupon on June 01, 2026 at the face value amount of $2.5 million. Effectively, the investor will earn $728,250.00 in interest ($2,500,000 - $1,771,750).

There are many high quality strips available from various bond issuers, such as the Federal Government of Canada and the Canadian provinces, as well as from banks and corporations. However, strips are not created and sold by issuers. Instead, once a regular bond is issued, it is stripped by an investment firm and sold to individual investors, as well as to institutional investors such as pension plans and mutual funds. Investors can participate in purchases of all sizes, from thousands to millions of dollars. For example, a single coupon of $2.5 million can be sold in lots of $5,000. ($5,000 is the minimum face value of any strip or bond available through Qtrade Investor).

Benefits of strips

An attractive alternative to bonds, strips offer several important benefits:

Known yield: with a set maturity date and a purchase price at a discount, you have a fixed yield
Low maintenance: no need to worry about reinvesting small amounts of interest every six months, possibly at a lower rate ("coupon reinvestment risk" is a feature of conventional bonds)
Liquidity: strips are actively traded, liquid instruments, so investors can deploy either an active trading or a passive buy-and-hold strategy
Control and flexibility: because the maturity timing and value are set, strips can be used strategically to match future known expenses, such as a child's education requirements. And strips can be purchased with staggered maturity dates, allowing you to ladder them in order to minimize risk and time your cash flows. Terms range from months, to decades.

Price volatility

Compared to conventional bonds that are stabilized by ongoing interest payments, strip prices can be more volatile. Changes in prevailing interest rates or in the issuer's credit quality can affect strips' present value. This is less of a concern if you plan to hold the strip until maturity, since it will mature at par.

Tax considerations

Strips that are held to maturity are treated as interest income per Canadian tax laws and not as a capital gain. Even though the income isn't paid until maturity or sale — under tax law an investor must account for the annual accrual of notional interest as investment income in the year earned, not the year received. A capital gain or loss, however, can be triggered if the note is sold prior to the maturity date.*
Strips are best suited for tax-deferred and tax-sheltered plans such as RRSPs, RRIFs, TFSAs and RESPs. The interest earned inside these plans is not taxable until withdrawn from the plan (or, with a TFSA, not taxable at all) and is tax sheltered while growing and earning inside the plan.*

Many investment-grade short-, medium- and long-term strips are available to Qtrade Investor clients. For help with fixed income trading, please speak to one of our investment representatives.

*If you have questions about potential tax implications, please contact Canada Revenue Agency or a qualified tax specialist.