What it means
Normally a bond pays a coupon (a regular interest payment) every six or twelve months and returns the principal at the end. With a strip, a financial institution splits these cash flows apart and sells each one as its own security.
Each coupon becomes one strip and the final principal repayment becomes another. STRIPS is the name used in the United States for Treasury securities separated this way, standing for separate trading of registered interest and principal of securities.
Similar programmes exist in other government bond markets. Because they are claims on the government, the credit risk is the same as that of the original bond.
The price of a strip is the present value of its single payment, meaning what that future sum is worth today after discounting at the market yield. The longer the time to maturity, the deeper the discount.
A strip maturing in twenty years sells for a much smaller fraction of its face value than one maturing in two years. Investors use strip bonds to match a known future liability, such as a tuition bill or a pension payment, with a known payment on a known date.
Companies and pension funds also use them for liability matching. The price swings more than that of a normal coupon bond when interest rates change, because the entire return is received at the end.
An important tax nuance applies in many jurisdictions. Even though no cash interest is received during the life of the strip, the annual accretion (the yearly increase in value towards face value) may be treated as taxable income.
Holders often favour tax-deferred accounts for this reason. Strip bonds should be distinguished from the strip options strategy.
They also differ from stripped mortgage securities, which split mortgage cash flows rather than bond coupons.
In practice
Real-world examples.
Example
A parent expects a $60,000 university bill in 15 years. She buys strip bonds maturing in that year at a discount and holds them in a tax-advantaged account. The strips will pay a known amount at a known time, with no coupon income to reinvest.
Example
A pension fund has a promise to pay members $20,000,000 in ten years. Its investment team buys strips with that maturity to lock in the funding, which removes the uncertainty about reinvesting coupons. The strips are recorded at fair value in its accounts.
Example
A bank's trading desk buys a Treasury bond and sells its coupons and principal separately to different investors. Some buyers want short-dated income, others want a long-dated lump sum, and the desk earns a small margin for creating the pieces.
Formula
Calculation
Price of a strip = face value / (1 + yield)^number of years
Suppose an investor wants a strip with a face value of $121,000 maturing in 2 years, and the market yield is 10% a year. The price is $121,000 / (1.10)^2 = $121,000 / 1.21 = $100,000. The investor pays $100,000 today and receives $121,000 in two years, a gain of $21,000. That gain equals a 10% annual yield: $100,000 grows to $110,000 after one year, and $110,000 grows to $121,000 after the second.Case study
Seen in the real world.
Willowbrook Foundation is an illustrative, fictional charity that promised to fund a scholarship of $150,000 on a fixed date eight years away. Its treasurer worried that if it held ordinary bonds, falling rates would make it difficult to reinvest the coupons at adequate returns.
She bought strips maturing on the funding date with a total face value of $150,000. At a yield of 5% a year the cost was about $101,500, which was within the charity's budget and locked in the final amount.
During the eight years bond prices moved up and down, and the value shown in the annual accounts moved with them. By maturity, though, the strips paid the full face value as planned. The illustrative lesson is that a strip trades price volatility during the holding period for certainty at the end.
Watch out
Common mistakes.
- Believing a strip bond pays no return because it pays no coupons, when the return is the discount earned over time.
- Ignoring the tax on accrued interest, which may be due each year even though no cash is received.
- Expecting the price to be stable, when long-dated strips are among the most price-sensitive bonds when rates move.
Questions
People also ask.
Are strip bonds safe?
Strips made from government bonds carry the credit risk of the government, but their market price can still fall sharply before maturity if interest rates rise.
What is the difference between a strip bond and a zero-coupon bond?
A zero-coupon bond may be issued as such from the start, while a strip bond is created by separating the parts of an existing coupon bond, though their cash flows look the same.
Why would an investor choose a strip?
Strips offer a single known payment on a known date and remove the need to reinvest coupons.
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