Strip Bond Basics

I have a few posts planned about strip bonds (also called zero-coupon bonds), but I thought I should give a crash course in case some readers aren’t familiar with them.

I think the majority of readers have a good understanding of Canada Savings Bonds; CSBs and the similar Ontario Savings Bonds were pretty much the only bonds I knew about for a long time. In fact, a $1000 CSB was my first investment when I was a child.

CSBs are pretty simple to understand. You buy them for a certain amount and receive interest on your investment. And since they can’t be transferred, the original buyer usually holds them to maturity.

Strip bonds work differently. Instead of buying them and receiving interest, they are bought at a discount, and “mature” at a certain value. This gives them an effect similar to compound interest.

In reality, strip bonds begin as all bonds (except for federal or provincial savings bonds). A government or corporation issues bonds that make set interest payments periodically. But then a middle-man (investment dealer or a bank) buys the bonds, and “strips” the interest payments from the bond. The dealer then sells each future interest payment, as well as the principle, at a discount to the amount that will be received by the end-buyer.

Here’s a simple example to illustrate: I am an investment dealer and buy the new 1 year bond from ISO Salt Corp. It costs $1000 and has a 5% interest coupon. If I were to hold the bond to maturity in 1 year, I would receive my $1000 back, plus 5% interest, which is $50.

But I don’t want to hold the bond to maturity; I want to sell the components separately. So I sell the future interest payment of $50 now for $47.62 (this price has the effect of 5% interest, as the buyer will receive $50 in one year’s time) and the principal of $1000 (called the residual) for $952.38 (i.e., the amount that, plus 5%, will equal $1000).

The two buyers wait the year, and each receives their money. $50 for the investor who bought the interest, and $1000 to the investor who bought the residual. Both increased their initial outlay by 5%.

And that’s strip bonds in a nut shell.

The above is a simplified version. In the real world, you’d most likely be looking at terms longer than one year, and the bonds would be discounted to reflect that.  Purchases are also usually at a $5000 of face-value minimum, so buying a $50 bond is unrealistic.

They have some certain advantages and disadvantages, but can be a great part of an investment strategy if used properly… but that’s the point of my future posts.

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2 responses to “Strip Bond Basics

  1. Dumb question: why would an investment dealer pay $1000 for a bond, then sell that bond for $47.62 + $952.38 = $1000? Where’s the profit?

  2. Hi Patrick,

    Not a dumb question at all. It’s a great question.

    The first thing to remember, though, is that my example is over-simplified in order to show the basic idea of strip bonds.

    There are several ways the investment houses make money on strip bonds:

    1. Through initial spread: If the investment house in question is the initial underwriter of the bond issue, they will get a discount on the bonds. So even though it is a 5% bond with a $1000 face value, they might only pay ISO Salt Corp. $999 dollars. Once they sell that into the market, they make money.

    2. Through use of the Yield Curve: I used a 1 year bond in my example, but in reality longer-term bonds would be used. Let’s say a 10-year bond.

    If 10 year rates are near 5% they will discount the principal and final interest payment at 5%. But 7-year, 5-year, 3-year, and 1-year bonds might be trading at 4%, 3%, 2% and 1% respectively.

    They will not discount a stripped interest payment 3 years from now at 5%, but rather 2% (even though it comes from a 5% bond) because once it is stripped, it becomes its own entity.

    So they can make money on these interest rate differences… because of this, investment firms are most likely to create strip bonds when the yield curve is steep.

    3. Through secondary spread: The bond market doesn’t work like the stock market. If you want to buy ISO Salt Corp’s common stock and I want to sell it, our brokers charge us commission and match up our order. Bonds, however, are usually sold out of a brokerage’s inventory. So they will buy the bond from you at one price, and sell to me at another price. It is a form of commission that is worked into the price of the bond.

    They make a lot of money on this spread. In fact, the moment you buy a strip bond you will have a loss in your portfolio, as you will not be able to sell it for the same price you bought it at.

    They really should be used for longer time horizons.

    I don’t know the inner workings of investment houses, but it wouldn’t surprize me if there are other ways they are making money.

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