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.