What it means
A standard bond is really a bundle of dated promises: a series of modest interest payments, called coupons, plus one large repayment of the face value on the maturity date. Coupon stripping unbundles that package so every promise trades as its own security, usually called a strip.
Nothing new is created; the same cash flows are simply sold separately rather than as a set. The commercial logic is cash flow matching.
A pension scheme that knows it owes a set amount in 2039 can buy a strip maturing in 2039 and know exactly what it will receive, instead of holding a coupon bond whose interim payments must be reinvested at rates nobody can predict today. Insurers, structured product desks and liability driven investors all buy strips for the same reason.
Mechanically, a dealer or custodian deposits the underlying bond with a settlement system and issues a separate claim against each dated cash flow. Several government bond markets run formal facilities for this, and the process is reversible: an investor who assembles a full set of matching strips can hand them back and reconstitute the original bond.
That reversibility is what keeps strip prices anchored to the price of the whole bond. Pricing a strip is pure discounting: take the single future payment and divide it by one plus the discount rate raised to the number of years until it lands.
Because there is no interim cash at all, a strip's price reacts more sharply to interest rate moves than a coupon bond of the same maturity, a property analysts describe as higher duration, meaning greater price sensitivity to rate changes. Two practical wrinkles matter for anyone holding strips.
In many tax regimes the annual build-up in value is taxable even though no cash arrives until maturity, so strips are often held inside tax-sheltered accounts. Individual strips also trade less frequently than the whole bond, so dealing spreads can be wider, particularly for odd maturity dates.
In practice
Real-world examples.
Example
A local authority pension fund knows it must pay $12,000,000 of lump sums in 2034. Rather than hold coupon bonds and worry about reinvesting the interest, it buys principal strips maturing in 2034 and locks the outcome in on day one.
Example
A private bank builds a structured note for wealthy clients. It buys a five-year strip that will be worth $1,000,000 at maturity for roughly $780,000, and spends the remaining $220,000 of the client's $1,000,000 on equity options, so the client cannot lose the original capital if markets fall.
Example
A bond desk notices that the assembled price of a full set of strips is $40,000 above the price of the underlying bond. It buys the bond, strips it through the settlement system and sells the individual pieces, capturing the difference less its dealing and custody costs.
Formula
Calculation
Price of a strip = Face value of that cash flow / (1 + r)^n, where r is the annual discount rate and n is the number of years until payment.
Take a $1,000,000 government bond with three years left, paying a 6% annual coupon, so it produces $60,000 at the end of years 1, 2 and 3, plus $1,000,000 of principal at the end of year 3. Assume the market discount rate for all maturities is 5%.
Coupon strip, year 1: $60,000 / 1.05 = $57,143.
Coupon strip, year 2: $60,000 / 1.1025 = $54,422.
Coupon strip, year 3: $60,000 / 1.157625 = $51,830.
Principal strip, year 3: $1,000,000 / 1.157625 = $863,838.
The three coupon strips are worth $57,143 + $54,422 + $51,830 = $163,395. Adding the principal strip of $863,838 gives $1,027,233 for the complete set, which is exactly what the intact bond is worth. The stripping process moved value around between buyers; it did not create any.Case study
Seen in the real world.
Northgate Pension Trust is a fictional retirement scheme used here purely as an illustrative case. Its actuary calculated that scheme members would draw $4,000,000 a year for each of the next ten years, and the trustees were tired of explaining to the board why returns swung whenever coupons had to be reinvested at whatever rate happened to prevail that month.
The trust bought a ladder of strips, one for each of the ten years, sized so that each maturity delivered the $4,000,000 required. The total outlay was lower than the face value because every strip was bought at a discount, and once purchased the trustees no longer had any reinvestment decision to make for that block of liabilities. Their quarterly reporting became far simpler.
The trade-off appeared two years later, when interest rates rose and the market value of the remaining strips fell sharply. Because the strips were being held to their maturity dates and matched to known payments, the trustees treated that mark-to-market swing as noise rather than as a loss, which is exactly the discipline this strategy demands.
Watch out
Common mistakes.
- Assuming a strip pays interest along the way. It pays nothing at all until maturity, when the single stated amount arrives, and any budget built on interim income from a strip will come up short.
- Treating strips as low risk because the issuer is a government. Credit risk may be small, but price sensitivity to interest rates is higher than for a comparable coupon bond, so the mark-to-market swings are larger.
- Ignoring the tax treatment. In many jurisdictions the annual accretion in value is taxed as income each year even though no cash has been received, which can create a funding problem for a taxable holder.
Questions
People also ask.
Who actually does the stripping?
Usually a bank, dealer or the official settlement system for the government bond market, acting on behalf of an investor who deposits the underlying bond.
Can stripped pieces be put back together?
Yes, an investor holding a complete matching set can reconstitute the original bond, and that possibility keeps strip prices in line with the whole bond.
Is coupon stripping the same as issuing a zero-coupon bond?
Not quite: a zero-coupon bond is issued that way from the start, whereas a strip is carved out of an existing coupon bond after issue, though the cash flow shape is identical.
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