What it means
The name describes the process. A financial firm buys an existing bond, places it in a trust, and the trust issues new certificates that represent claims on the bond's payments.
The trust is repackaging the original security into a different form. The main purpose is access and convenience.
A corporate bond may normally be traded in blocks of $1,000 or more, whereas the certificates are often issued in small units such as $25 and listed on an exchange. This allows individual investors to buy an income security with a price they can follow throughout the day.
The cash flows are passed through. When the issuer pays interest on the underlying bond, the trustee distributes it to the certificate holders, and when the bond matures, the principal is distributed.
Some structures add an interest rate swap, which is a contract that exchanges one type of interest payment for another, so a fixed coupon can be converted to a floating one. The credit risk is that of the underlying bond, not of the sponsoring firm.
If the bond issuer defaults, the certificate holders suffer, whatever the quality of the firm that created the trust. This is why investors should look at the identity and creditworthiness of the underlying issuer and not only at the name of the certificates.
Other risks include trading prices that differ from the value of the underlying bond, limited trading volume, and call features. If the underlying bond can be redeemed early by its issuer, the certificates may be redeemed as well.
Trust documents set out the rights of the holders and the powers of the trustee. STRATS belong to a wider family of repackaged securities that sponsors have created under different names.
Their features are broadly similar, but each series has its own terms, so each should be read individually.
In practice
Real-world examples.
Example
An individual investor wants regular income from a well-known telecom company's debt but cannot buy a $1,000 bond in small amounts easily. She buys 200 certificates at $25, which cost $5,000, and receives quarterly payments through her brokerage account. She can sell them on the exchange in a few minutes.
Example
A broker-dealer holds a large position in a corporate bond and wants to sell it to retail clients. It places the bond in a trust and sells certificates in $25 units. The firm raises cash and earns a fee for structuring the deal.
Example
A retired couple notice that the certificates linked to a particular bond trade below the original $25. Their adviser explains that the price reflects rising interest rates and concern about the issuer's credit. The couple decide whether to hold for the income or to sell.
Formula
Calculation
Current yield on a certificate = annual cash distribution per certificate / market price of the certificate
Suppose a trust holds $20,000,000 of a 6% corporate bond and issues 800,000 certificates at $25 each. The bond pays 6% x $20,000,000 = $1,200,000 of interest a year. Per certificate that is $1,200,000 / 800,000 = $1.50, which is a 6% yield on the $25 issue price. If the certificates trade at $23, the current yield is 1.50 / 23 = 6.52%, ignoring trust expenses.Case study
Seen in the real world.
Pinecrest Securities is an illustrative, fictional broker-dealer that wanted to offer retail clients exposure to a high-quality industrial company's bonds. The bonds were issued in large blocks, which put them out of reach of most of its clients.
The firm bought $30,000,000 of the 5% bonds, placed them in a trust and issued 1,200,000 certificates at $25. Each certificate paid $1.25 a year, and the units were listed on an exchange, so clients could trade them like shares.
When the industrial company later had its credit rating cut, the certificates fell to $21, even though the bond was still paying interest. The illustrative lesson is that buyers of repackaged securities take on the credit risk of the underlying issuer, and market prices move with it.
Watch out
Common mistakes.
- Assuming that the sponsoring firm guarantees the payments, when the risk is that of the underlying bond issuer.
- Ignoring call features, which can lead to early redemption at a time that suits the issuer.
- Treating the price as a stable $25, when exchange-traded units can trade well below or above that level.
Questions
People also ask.
What does the trustee do?
The trustee holds the underlying bond, collects its payments and distributes them to certificate holders according to the trust documents.
Why would an investor buy STRATS instead of the original bond?
They are available in small denominations and trade on an exchange, which makes them easier to buy and sell.
Are STRATS the same as asset-backed securities?
They are similar in using a trust to pass through cash flows, but STRATS hold one bond, whereas typical asset-backed securities hold a pool of many loans.
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