Strip bonds

Strip bonds (also known as zero coupon bonds) are defined as future-dated coupons (interest components) and residuals (principal components) which are derived from an underlying bond and are traded separately from the underlying bond.

How strip bonds work
Stripped bonds do not pay regular interest payments. The bond is purchased at a discount to the face value (nominally $100); that face value will be paid only on maturity. The exact amount of the discount is determined mathematically. To take a simple example, at an interest rate of 5%, a bond coming due one year from now is worth only roughly $95, not $100. To use an on-line bond calculator for a stripped bond, enter a coupon rate of zero.

Because stripped bonds do not pay regular interest payments they do not have the reinvestment risk of conventional bonds. This trait may be useful for investors trying to match future cash flow obligations. Because they have no coupons and no cash flow is obtained until the strip matures, strip bonds have a duration equal to their term to maturity. This means that their prices are more volatile that of conventional interest-paying bonds.

Availability and use
Stripped bonds are created from a variety of underlying bonds, including federal (Government of Canada), provincial, municipal, and corporate issues.

Terms-to-maturity typically range from six months to 30 years.

In November 2018, the total face value of "underlying bonds stripped by book-entry" at Clearing and Depository Services Inc (CDS) was about 100 billion dollars.

Stripped bonds can be used for laddering strategies in registered accounts. They can also be used for liability matching strategies.

Strips are considered less liquid than conventional bonds of the same issuer, term and credit rating. Therefore, they should generally be purchased by individual investors with the intention of holding to maturity.

How strips are created
The Government of Canada, nor most other issuers in Canada, do not issue strip bonds. Strip bonds are created by investment dealers by separating a conventional bond into a) a residual bond and b) strip coupons of all future coupon payments. Stripping bonds can be a profitable activity for investment dealers. The strips may be in the form of depository book-entry strip bonds, receipt securities, or in specie (physical strip bonds).

Annual taxation
Investors need to be aware that stripped bonds held in taxable (non-registered) accounts will be subject to tax on the imputed interest every year, even though no money is received. Unless held in a registered account, the tax treatment and record keeping requirements of strip bonds is complex.

More specifically, the Canada Revenue Agency has indicated that purchasers of strip bonds will be treated as having purchased a “prescribed debt obligation” within the meaning of the Regulations. Accordingly, a purchaser will be required to include in income in each year a notional amount of interest, notwithstanding that no interest will be paid or received in the year.

Therefore, these instruments may be more attractive to non-taxable accounts, such as self-directed Registered Retirement Savings Plans, Registered Retirement Income Funds, Deferred Profit Sharing Plans, Registered Education Savings Plans, pension funds and charities, than to taxable accounts.

Bond calculator
Odlum Brown provides a very useful free Bond Calculator (Excel). When use bond calculators for strip bonds, remember to enter "0" as the value for coupon as no regular interest payments are received.