Strip Bonds Information Centre

The first strip bonds

In the early 1980's, investment dealers in the United States began clipping coupons from bearer government bonds and selling the individual pieces as separate securities. The product allowed investors to lock in the very high yields that were available at that time, without worrying about the risk of not being able to re-invest future interest payments at the same high rates.

In Canada, some sources peg the start of strip bonds as being in 1982. However, since physical strip bonds are easily created with scissors, it probably is impossible to pinpoint the exact start date in either Canada or the U.S.

Strip bonds had other advantages for investors, such as increased potential for capital gains (compared to conventional bonds) and allowing investors to customize the cash flows to meet their individual needs.

The market started first with physical stripping of the bonds, then moved to receipt security strip bonds, and finally book-entry (electronic) stripping through securities depositories.

Canadian investment dealers were quick to import the concept into Canada. Canadian dealers stripped not only Government of Canada bonds, but also provincial bonds, provincial agency bonds, and even bonds from local governments,subsidized institutions such as universities and hospitals, and then corporate bonds in 1989.

The idea was adopted by France in 1991 and in other countries later. In these countries, the service seems to be limited to government bonds only.

Canada probably still holds the record for stripping a bond with the longest maturity date - a 99 year bond that was stripped around 1989. Currently, the longest maturity date for Canadian strip bonds is a bit shorter, going only to 2097. The longest in the U.S. (as of Oct. 2004) is 2031, compared to France at 2032, Belgium at 2035 and the U.K. at 2038.

Physical strip bonds

Investment dealers created the first strip bonds by physically clipping the future-dated coupons from bearer bonds, so that the coupons and the principal (called the residual) could be held and traded separately.

In Canada, bond certificates with a face value (or denomination) of $100,000 were stripped most frequently. Certificates of other denominations, as small as $5,000 and as large as $1,000,000, also were stripped. For a $1,000,000 bond paying 14% semi-annually, each coupon was worth $70,000 on the payable date.

This form of strip bond had the advantage of relatively low costs to create (if you ignored the significant staff time required to separate all the coupons and residuals and the risk of loss), but it created significant risks and costs for everyone who handled them or owned them.

The small size of the coupons (often less than 2 cm by 5 cm - 1" x 2" - or about the size of an adult's thumb) meant that it was easy to lose them. Because the coupons and residuals were payable to the bearer, if you lost them or they were destroyed, you could not get replacement certificates.

There also was no way to determine if the coupons or residuals were authentic.

The advantages of this form of strip bond were that 1) the cost of creating them was perceived to be low and 2) the strip bonds from the same underlying bond were all equivalent, regardless of which investment dealer created them. The big disadvantages were the high risks and costs for safekeeping them.

Since these disadvantages affected the purchasers, the investment dealers had little incentive to shift away from physical strip bonds. In Canada, dealers began to move to alternative forms of strip bonds once they realized that they were holding large values of physical strip bonds for their retail clients.

In the U.S., the government and its agencies were successful, for the most part, in using moral suasion to convince the investment dealers to not strip the bonds physically. However, enough bonds were physically stripped that the Federal Reserve Bank of New York introduced its Coupons Under Book-Entry Safekeeping (CUBES) service and BECCS (BEarer Corpora Conversion System) for the residuals.

In Canada, the government was less successful and the physical strip bonds became the most popular form of strip bond for a while, with the total face value of these strips reaching about $20 billion CAD. Significant efforts were required to switch the industry to the lower-cost book-entry strip bonds. This switch allowed investors and financial dealers and institutions to save several million dollars annually in costs. In 2002, Canada completed a massive undertaking to convert the remaining physical strip bonds to depository book-entry strip bonds. Government of Canada physical strip bonds were verified by, and are now held by, the Bank of Canada.

For the other issuers, the Canadian depository arranged for the reconstruction of the original certificates (including matching the certificate numbers on each coupon and residual). This project succeeded in converting approximately $5 billion CAD (face value) in physical strip bonds to book-entry strip bonds.

In other countries, physical strip bonds were never a factor, probably because the product was introduced after the issuers had eliminated bearer coupon bonds.

See Canadian stories for more information.

Receipt security strip bonds

To address these problems with physical strip bonds, some investment dealers began offering new types of strip bonds that would allow the purchaser to receive a certificate with their name on it that represented the strip bonds.

A trust company or bank would maintain a register of the holders for these strip bonds, in the same way that records are kept of registered holders of a company's shares. This ensured that the holder could obtain a replacement certificate if necessary.

This form of strip bonds was issued in both Canada and the United States. The first ones issued in the U.S. in 1982 included TIGRs, LIONS, and CATS.

For some of these products, such as the Canadian TIGRs (Term Investment Growth Receipts), the trust company or bank would hold the physical strip bonds and allow the holder to exchange the registered certificate for a physical strip bond.

For others, such as Sentinels in Canada, the trust company or bank would hold the underlying bond in fully-registered form and not allow exchanges.

For both types of products, the trust company would collect the payment on the underlying security and then pay the holders of the certificates.

This form of strip bonds had significant disadvantages, including:

  1. the high costs of creating them (which were passed through to the investors) and
  2. the proliferation of proprietary brand names (such as TIGRs, Sentinels, Cougars, Nuggets, etc.), which meant that the strip bonds created by different investment dealers were not equivalent investment instruments, even if they shared the same underlying bond.

Depository book-entry strip bonds

In 1985, the Federal Reserve Bank of New York (FRBNY) began offering its STRIPS service (Separately Traded Interest and Principal Service). The original service included the use of generic security numbers for interest payments. (Generic security numbers means that a single number is used to identify all payments having the same issuer, payment date, payment type [e.g. interest or principal], payment currency, and no distinguishing features.)

In 1987, the Canadian Depository for Securities (CDS) launched a similar service, but without using generic security numbers. (Canada introduced generic security numbers 5 years later and expanded the concept to include residuals.)

Later, several other countries began offering similar services. Under these services, the securities depository holds the underlying bonds and the strip bonds are created only as electronic ledger entries on the records of the depository. Once created, the strip bonds are held and transferred only within the depository system.

These strip bonds offer some features that are not available for the two earlier types of strip bonds, including:

The advantages of this form of strip bonds include:

  1. having the lowest costs to create and hold the strip bonds, and
  2. offering the greatest liquidity for investors, by using generic security numbers and ensuring that only one set of strip bonds is created for each underlying bond.

In the markets where this service is available, this is the standard form of strip bond that is offered for sale today.

For additional background on the development, see:

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Copyright Keith Campbell ©2002-6. All rights reserved.