What it means
When a bond is stripped, each coupon and the final principal repayment becomes its own security. The holder of a strip receives nothing until the maturity date of that piece, so the whole return comes from buying at a discount and being paid the full face value later.
The stripped yield expresses that gain as an annual percentage. The yield is not set by a coupon rate, because there is no coupon.
It is set by the market price, which reflects what investors demand to lend for that length of time. If the price falls, the yield rises, and if the price rises, the yield falls.
The measure matters because it allows a like-for-like comparison. A ten-year strip and a ten-year coupon bond can look very different on the surface, yet both can be reduced to a single annual yield.
Treasury teams and pension funds use stripped yields to build yield curves, which plot yield against time to maturity and show what the market expects for interest rates. Strips from government bonds also offer a clean picture of the risk-free rate for each maturity.
Analysts use those yields to discount future cash flows in valuation models, because each future payment can be matched to a strip with the same date. This is one reason strips are described as a building block of fixed-income pricing.
A nuance is the compounding convention. Many bond markets quote yields on a semi-annual basis, while others use annual compounding, so two yields can look different even when the price is the same.
Always check the convention before comparing figures from different markets or data providers. Stripped yield should not be mixed up with the current yield or the coupon yield of the original bond.
Those measures describe a stream of interest payments, whereas the stripped yield describes a single-payment return that is fully realised only if the strip is held to maturity.
In practice
Real-world examples.
Example
A pension fund compares two investments that pay out in 2 years: a strip priced at $100,000 for $121,000 at maturity, and a corporate bond with a 9% coupon. It converts both to yields and finds the strip earns 10%. The comparison tells it which offers the better return for the same time period.
Example
A bank treasurer building a yield curve collects prices of government strips at 1, 2, 5 and 10 years. She converts each price to a stripped yield and plots them to see how the market prices time. The curve is then used to value the bank's long-term loans.
Example
A retail investor sees a strip advertised at a price of $64,000 for a $100,000 payment in 10 years. The adviser works out that this equals about 4.6% a year, which he can compare with his savings account. He decides whether the extra return is worth locking the money up.
Formula
Calculation
Stripped yield = (face value / price)^(1 / number of years) - 1
Suppose an investor buys a strip with a face value of $121,000 that matures in 2 years for a price of $100,000. The ratio of face value to price is 121,000 / 100,000 = 1.21. Taking the square root, which is the power of 1/2, gives 1.10. Subtracting 1 gives a stripped yield of 0.10, or 10% a year. As a check, $100,000 x 1.10 x 1.10 = $121,000.Case study
Seen in the real world.
Brightwater Insurance is an illustrative, fictional insurer that must pay out a block of annuities in exactly 5 years. Its investment team considered buying strips and compared several maturities. One strip with a face value of $13,310,000 was offered at a price of $10,000,000 with a 3-year maturity.
The team calculated the stripped yield as (13,310,000 / 10,000,000)^(1/3) - 1. The ratio is 1.331, whose cube root is 1.10, so the yield is 10%. They noted that the yield was well above the rate they had assumed in their pricing.
After checking the credit quality of the issuer, they bought the strips as part of a ladder of maturities. The illustrative lesson is that converting prices into yields turns a confusing set of offers into a simple ranking.
Watch out
Common mistakes.
- Calculating the yield as the total gain divided by the price without adjusting for the number of years, which overstates the annual return.
- Comparing a strip yield quoted semi-annually with another quoted annually, as if they were the same basis.
- Assuming the yield is guaranteed if the strip is sold early, when the sale price depends on market rates at that time.
Questions
People also ask.
Is the stripped yield the same as yield to maturity?
For a single-payment strip, they are effectively the same figure, since the strip has only one cash flow to maturity.
Why does the yield rise when the price falls?
A lower price means the investor pays less to receive the same fixed payment, so the percentage return is greater.
Can the stripped yield be negative?
It can in unusual markets if investors pay more than the face value, but this is rare.
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