Investors have a lot of options when it comes to fixed-income securities. One investment in this asset class that is often overlooked and misunderstood is the strip bond. 

Strip bonds are purchased at a discount to their face value and they have a number of advantages over conventional bonds. If the security of knowing what your return will be is important to you, strip bonds are an ideal option.

But how do they work?

What is a strip bond?

Bonds have two components: the principal and the coupons. A strip bond, also known as a zero coupon bond, is created when an investment dealer separates, or strips, the principal from the coupon payments. Investors can then purchase the principal, also called the residual, or the coupons at a discount to their face values. The lower the price, the higher the yield.

The investor, therefore, makes a return by cashing in the strip bond for its par value at maturity.

As an example, say you buy a five-year 10,000 face value strip bond at a price of $90.18. The price is based on a par value of 100 so your purchase price would be $9,018. Your return would be the difference between the purchase price and the maturity value, in this case $982. This would represent a yield-to-maturity of 2.08% per year.

Understand Strip Bonds and Their Benefits 

Strip bonds offer competitive returns, and the yield-to-maturity quoted at the time of purchase is unlikely to change. A predictable return is appealing to investors who are saving for the future and know they will need a certain amount of money by a certain date. A wide range of maturity dates gives investors the flexibility to pick a term-to-maturity that matches their goals.

They are suitable for a range of investment objectives. From households saving for retirement or a loved-one’s education, to institutional investors looking to maximize yields while protecting their principal.

Interest on strip bonds is paid at maturity. Unlike interest-bearing bonds, which have semi-annual coupon payments, they do not generate regular income as they mature. Instead, the accrued interest is reinvested at the same yield as the time of purchase. 

Because the yield-to-maturity stays unchanged, they are easy to understand and suitable for investors planning to deploy a passive, set-and-forget strategy.

For investors concerned with a predictable return, holding a strip bond to maturity avoids the issue of reinvestment risk. Because interest rates fluctuate, it is possible that an interest-bearing bond’s coupons could be reinvested at a lower rate than the time of purchase. If this happens, the overall return will be lower than originally quoted. 

If you do not plan on holding zero coupon bonds until maturity, they have an active secondary market. It is important to note that in a rate rising environment, prices of bonds and strip bonds generally will go down. If you are interested in trading them, they have the greatest growth potential at the peak of a rate hiking cycle.

Importance of issuers

Investment dealers create zero coupon products from a range of issuers, including high-quality federal or provincial government bonds which have some of the best credit ratings available. 

Government bonds provide the highest degree of security because there is a very low probability they will not be able to pay back the bond.

Tax considerations

Accrued interest on a strip bond is considered income rather than a capital gain. Even though the yield is paid at maturity, you pay taxes on interest not actually received .

Therefore, most investors holding strip bonds keep them in a tax deferred plan, such as an RRSP, RESP, or TFSA.

As with any bond, if you sell it at a higher price than the purchase price, you must pay a capital gains tax. Conversely, selling at a lower price than you paid counts as a capital loss.

History of Strip Bonds

Strip bonds were first introduced in the U.S. market by investment dealers in the 1960s. In Canada, strip bonds created by the Government of Canada have been available since 1982. 

What is interesting is that in the 1980s, investment dealers had to physically remove, or strip, the bearer coupons from the bond certificate. For reference, a bearer bond is a physical certificate with coupons attached that are used to redeem the interest payments.

Investment dealers would then physically transfer the bearer coupons and the residue to the appropriate parties involved.

At the time, the physical aspect of strip bonds proved to be highly illiquid and limited the size of the strip bond market in Canada for most of the 1980s. It was not until 1987 that The Canadian Depository for Securities Limited (CDS) began to offer bonds to be stripped electronically.

Strip bonds from high-quality issuers are an ideal investment if you are looking for a discounted, low-risk bond option. Compound interest and the security of knowing your return make them an ideal option for risk-off investors.

For more information, speak to your Cash Management Group at Canaccord Genuity advisor. Call us on 604.643.0101 or email cashgroup@cgf.com.