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.[1][2][3]
How strip bonds work
Stripped bonds do not pay regular interest payments.[2][3] The bond is purchased at a discount to the face value (nominally $100); that face value will be paid only on maturity.[1][2] 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.[2][3] This trait may be useful for investors trying to match future cash flow obligations.[1] 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.[2] This means that their prices are more volatile that of conventional interest-paying bonds.[3][1]
Availability and use
Stripped bonds are created from a variety of underlying bonds, including federal (Government of Canada), provincial, municipal, and corporate issues.[1]
Terms-to-maturity typically range from six months to 30 years.[3]
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.[4]
Stripped bonds can be used for laddering strategies in registered accounts. They can also be used for liability matching strategies.[2]
Strips are considered less liquid than conventional bonds of the same issuer, term and credit rating.[1] Therefore, they should generally be purchased by individual investors with the intention of holding to maturity.[1]
How strips are created
The Government of Canada, nor most other issuers in Canada, do not issue strip bonds.[2] 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.[5] The strips may be in the form of depository book-entry strip bonds, receipt securities, or in specie (physical strip bonds).[6]
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.[7] Unless held in a registered account, the tax treatment and record keeping requirements of strip bonds is complex.[7]
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.[1]
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.[2]
Bond calculators
When use online bond calculators for strip bonds, remember to enter "0" as the value for coupon as no regular interest payments are received.
See also
References
- ^ a b c d e f g h "Strip Bonds and Strip Bond Packages Information Statement". Canadian Investment Regulatory Organization (CIRO). June 2014. Retrieved February 28, 2018.
- ^ a b c d e f g h Bank of Canada, The Canadian market for zero-coupon bonds, Bank of Canada Review Winter 1996-1997, viewed December 23, 2018.
- ^ a b c d e BMO Nesbitt Burns, Investing in strip bonds, viewed December 22, 2018.
- ^ Clearing and Depository Services Inc (CDS), Summary statistics November 2018, viewed December 23, 2018
- ^ James Hymas, Yields of Bonds and Strips, Canadian MoneySaver, May 2009, viewed December 22, 2018.
- ^ Strip Bonds Information Center, Strip bond definition, viewed January 29, 2021.
- ^ a b TaxTips.ca, Tax Treatment of Income From Investments in Non-Interest Paying Bonds (Strip Bonds), viewed December 23, 2018.
External links
- "Tax treatment of investments in strip bonds". TaxTips.ca.
- Financial Wisdom Forum topic: "Newbie Tax Questions on Strips"
- Clearing and Depository Services Inc.: Strip bond information
