Involvement of issuers
In most countries, the issuers of the bonds being stripped have been involved in the development of the strip bond markets, either directly or through their fiscal agents. Generally, they have applied the same principles that they follow for normal government bonds, to encourage liquidity in the strip bonds. To achieve this, most countries have restricted (at least initially) the bonds that are eligible for stripping. Limits have been based on:
- the type of instrument (e.g., bonds, notes, zero coupon bonds, and/or T-bills (Treasury bills) may be excluded from the service)
- the interest payment dates (e.g., only issues paying on specified dates are eligible)
- the term to maturity of the underlying bond (e.g., only bonds maturing in more than 5 years are eligible)
- the date on which the instrument was first issued (e.g., only bonds issued on or after a certain date are eligible)
- the issuer of the bond (e.g., only bonds issued by the government itself can be stripped)
Canada was the exception to this general practice. Here, physical strip bonds dominated the early strip bond market. Since these could be created by physically clipping all future-dated coupons from an existing bond certificate, financial institutions did not see the need to consult with the issuer.
This approach allowed traders to create whatever strip bonds that they could sell to investors. The Bank of Canada, the issuers, and issuer agents were powerless to stop the physical stripping of bonds despite valid concerns about the risky practice.
When the Canadian Depository for Securities (CDS) started its strip bond service, the issuers again had no direct say in the guidelines for the service. (Even the Bank of Canada had no official say at first, as CDS only became subject to their oversight in 1989, more than 2 years after starting the strip bond service.)
Because CDS had to compete with physical stripping of bonds and there was strong retail demand for strip bonds (including illiquid issues), the Canadian service became much more flexible than elsewhere. Accordingly, CDS established much broader characteristics, with limits based primarily on its system and operational constraints. As these constraints were removed, CDS extended the eligibility criteria for the service.
For example, initially CDS was unable to support the stripping of bonds where the payment amount was alternately rounded up and down. These bonds paid interest where the dollar amount on a $1,000 certificate resulted in a fraction of one cent. This would occur if the bond paid a semi-annual coupon rate of, say, 10.125%. In this case, the issuer would pay $50.62 for one payment and $50.63 for the next. The issuers applied the same rates to all holdings in the issue, regardless of the actual certificate denomination.
Other initial limitations included:
- bonds with long or short coupons (e.g., the rate for the first interest payment being higher or lower than the amount for the subsequent interest payment dates)
- bonds with multiple interest rates (e.g., bonds where the interest rate increases/decreases on a future date)
- bonds with mixed currencies (e.g. bonds paying interest in US dollars and the principal in Canadian dollars)
- bonds that are callable by the issuer or retractable by the investor prior to the maturity date of the bond
There are two main limitations remaining in the Canadian system today:
- the limitation on the use of generic strip bonds for corporate issues, and
- the use of separate security numbers for interest and principal payments having the same issuer, payment date, and payment currency (and no other distinguishing features).
In both cases, the limitations could be removed if there was general agreement to do so and CDS agreed to make the necessary changes to its operations, since CDS already has the basic legal framework in place to support it.
Issuers benefited from the introduction of strip bonds as it increased the demand for their bonds. Once generic strip bonds were introduced in Canada (the only market to introduce generic security numbers for strip bonds after implementing the service), issuers found that there were additional benefits to using standard interest payment dates for their new bond issues.
When CDS introduced its reconstitution service changes in 2001, issuers gained additional benefits. In Canada, some provincial issuers found that they could issue medium term notes at a higher price if the maturity date matched that of an existing marketable bond, since the investment dealer had the option, through CDS, to convert the medium term note into the marketable bond. This also increases the liquidity of the marketable bond, and thus makes it more attractive in the market.
The Canadian approach to strip bonds has proven that investors in strip bonds are not always looking just for liquidity in the strip bond market, as evidenced by the very low quantities of some strip bonds (less than $5,000 for some). The flexibility to match up future income to future payment obligations or for longer-term savings may be more important to some investors.
For additional background on the development, see:
NextCopyright Keith Campbell ©2003-2005. All rights reserved.
