Strip Bonds Information Centre

Generic strip bonds

The introduction of generic strip bonds added great value to the bond market. Generic strip bonds is the term used in the industry for the use of a single security identification number for strip bonds having equivalent characteristics. In most countries, this means only interest (coupon) payments having the same issuer

In most markets, generic strip bonds were introduced as part of the initial service, with the exception of Canada, which delayed the official use of generic strips for five years. Informally, the Canadian industry had been treating physical strip bonds having the same issuer, payment date, and payment type (interest or principal) as equivalent.

Some markets (but not Canada) have introduced generic strip bonds for receipt security strip bonds derived from corporate bonds. Investors should note that there are risks in doing this and should ensure that they fully understanding this risks fully.

In Canada, prior to the introduction of generic strip bonds and other enhancements to the strip bond service, there was great variation in the yields on Government of Canada bonds.

In some cases, bonds, identical except for the coupon rates, had differences of as much as 70 basis points (0.70%) in the yield. Investors and traders were not pricing bonds solely on the basis of credit risk and time to maturity of the different cash flows that the bonds represented.

These differences were reduced substantially with the introduction of generic strip bonds and strip bond packages in 1993. In fact, the changes happened so quickly that the Canadian authorities investigated the cause of the change. They concluded that there may have been some other factors involved, but the strip bond changes were a significant factor.

When the Canadian reconstitution service was enhanced in 2001, these differences were virtually eliminated. Usually the yield difference is very small (+/- 0.01%), but occasionally an off-the-run bond is reported to have a yield that is .04% lower than the corresponding on-the-run bond! This compares very favourably to the U.S. Treasury market, where the off-the-run bonds consistently have a higher yield than the corresponding on-the-run bonds, despite the higher liquidity in that market.

I would suggest that the main reason is that it created new options for traders that encouraged them to price bonds on the basis of the credit risk and the present value of the cash flows. Each new enhancement effectively created additional options on the bonds. See Strip bonds and the efficiency of the bond market for more discussion of this issue.

The Canadian market has taken this further than any other. There are different options or stages of development created, depending on the functionality offered. These stages are outlined below, based on the services currently offered in Canada and potential future enhancements.

Most countries are only at stage 2. Canada is at the 5th stage, with the potential to move to the 6th stage if the industry agreed to make this move.

Stages of development

1. Stripping and reconstitution of bonds using non-generic strip bonds

   • Allows a bond to be exchanged into the related strip bonds and vice versa
   • Supported in Canada for bonds that do not satisfy the criteria for use of generic strip bonds; not available in other countries
   • Strip bonds from different underlying bonds are not considered equivalent, which limits the options available to traders
   • Because the interest strip bonds are limited to a single issue, their liquidity tends to be quite low, which in turn limits the value of the option to strip bonds
   • One of the problems in reconstituting these bonds is identifying the holders of the related strip bonds and then convincing them to sell the strip bonds, which limits the value of the reconstitution option

2. Stripping and reconstitution of bonds using generic interest strip bonds

   • Allows a bond to be exchanged into the related strip bonds and vice versa
   • Supported by all countries offering a strip bond service
   • Liquidity of interest strip bonds increases if the issuer has issued multiple bonds that pay interest on the same dates, since these strip bonds are considered equivalent
   • If there is demand for a particular interest strip bond and multiple underlying bonds are related to it, traders can create the strip bond by stripping any of the related underlying bonds
   • If the price of one of the underlying bonds becomes expensive relative to the other related bonds, traders have an additional option for reconstituting the expensive bond, by:
     • Purchasing and then stripping a related bond to create all (or most of) the interest strip bonds
     • Purchasing the principal strip bond (and any missing interest strip bonds) on the open market
     • Using the newly-created and purchased strip bonds to reconstitute the expensive bond and then sell the expensive bond

3. Stripping and reconstitution of bonds using generic interest and principal strip bonds

   • Allows a bond to be exchanged into the related strip bonds and vice versa
   • Supported only in Canada
   • Liquidity of interest strip bonds increases if the issuer has issued multiple bonds that pay interest on the same dates, since these strip bonds are considered equivalent
   • Liquidity of principal strip bonds increases if the issuer has issued multiple bonds that mature on the same dates, since these strip bonds are considered equivalent
   • If there is demand for a particular interest or principal strip bond and multiple underlying bonds are related to it, traders can create the strip bond by stripping any of the related underlying bonds
   • If the price of one of the underlying bonds becomes expensive relative to the other related bonds, traders have an additional option for reconstituting the expensive bond, by:
     • Purchasing and then stripping a related bond to create all (or most of) the interest and principal strip bonds.
     • Purchasing the principal strip bond (and any missing interest strip bonds) on the open market
     • Using the newly-created and purchased strip bonds to reconstitute the expensive bond and then sell the expensive bond
   • Normally, the reconstitution of the expensive bond would be limited to the amount of that bond that had been previously stripped

4. Creating and separating strip bond packages

   • Allows the strip bonds to be combined together into a single security that is traded and held separately from both the strip bonds and the underlying bonds
   • Supported only in Canada
   • Liquidity of the strip bonds decreases to the extent that the strip bonds are included in strip bond packages
   • Some investors may consider the strip bond packages to be equivalent to a bond from the same issuer, but because the package does not share a security number with a bond, the packages usually trade at a discount
   • If there is excess demand for a particular bond, traders can create a strip bond package that has the same cash flow characteristics
   • If the price of a principal strip bond becomes expensive to the interest strip bond having the same payment characteristics (i.e., same issuer, payment date, etc.), traders have the option of creating a strip bond package using interest strip bonds to replicate the same cash flow (assuming that sufficient quantity of the interest strip bonds exist)

5. Making strip bond packages equivalent to original-issue bonds having the same characteristics

   • Allows traders to create additional quantities of a bond that is expensive relative to a strip bond package containing the same strip bonds that could be created by stripping the expensive bond. NOTE: This option requires that the securities depository assign generic security numbers to both interest and principal strip bonds. Currently, only Canada does this.
   • Liquidity of the strip bonds decreases to the extent that the strip bonds are included in the strip bond package
   • Liquidity of the expensive bond increases
   • If there is demand for a particular bond, traders can create a strip bond package that has the same cash flow characteristics by stripping another bond that has the same characteristics and that also qualifies for generic strip bonds, by:
     • purchasing a less expensive bond having the same maturity date
     • stripping the less expensive bond
     • using the resulting strip bonds to reconstitute the expensive bond
     • selling the expensive bond

6. Using payment strip bonds, instead of interest and principal strip bonds

   • Increases the liquidity of interest and principal strip bonds that share the same issuer, payment date, and other characteristics
   • Increases the opportunities for reconstituting bonds, by increasing the number of bonds that potentially can be used to create the required strip bonds (provided that the issuer has multiple bonds paying on the same dates)
   • Offered in Canada, but not being used at the present time

Copyright Keith Campbell ©2003-2005. All rights reserved.

Suggested reading on bonds:

In Your Best Interest: Fixed Income Investment Markets Explained for the Investing Public, by Hank Cunningham   NOTE: The author of this book has extensive industry experience in the Canadian fixed income markets, including trading strip bonds. There is a lot of information on strip bonds in this newly published book. He is a regular guest on ROBTV. Visit his web site www.inyourbestinterest.ca. See Canadian stories for some stories from this book and some additional comments.

Naked Guide to Bonds: What You Need to..., by M. Brandes

Getting Started in Bonds, 2nd Edition, by Sharon Saltzgiver Wright

The Bond King: Investment Secrets from Investment Secrets from PIMCO's Bill Gross, by Timothy Middleton

Bond Portfolio Management, 2nd Edition, by Frank J. Fabozzi

Bond Markets: Analysis and Strategies, by Frank J. Fabozzi

Fixed Income Securities and Derivatives Handbook, by Moorad Choudhry

Bond Evaluation, Selection, and Management, by R. Johnson