For investors, the main advantages and disadvantages of strip bonds and packages are outlined below. Investors should seek professional advice to determine if these apply to their situation.
Strip bonds
Advantages
- You know what the return on your investment will be if you hold it to maturity
- If you bought the strip bond with a yield of 5%, you will earn that 5% each year until the strip bond matures
- You know the amount that you will receive at maturity (except for indexed stripped bonds)
- If the strip bond has a face value of 10,000, you will receive 10,000 at maturity, in whatever the currency units are
- If the strip bond is indexed, the maturity value is normally adjusted by the index
- You may be able to realize a capital gain, instead of interest income, if interest rates fall
- If yields on the strip bond fall after you purchase it, the value of your strip bond will increase, resulting in a capital gain - which in many countries is taxed at more favourable rates than interest income
- You may have possible tax savings by holding a series of strip bonds instead of a conventional bond from the same issuer that has the same cash flows
- On strip bonds, most countries require that you report the return based on the yield annually. So if the yield is 5%, on a $2,000 strip bond, you would report the accrued interest income annually. But if you bought a bond with a 10% coupon rate, you would report $100 interest income annually and then have a capital loss at maturity. In a case such as this, depending on your tax situation, it may be better to purchase a series of strip bonds that replicate the cash payments of the bond itself.
Disadvantages
- Because the market for strip bonds can be illiquid, you may not be able to sell them when you want to
- Because many strip bond issues are traded much less frequently than the underlying bond, the secondary market for strip bonds is not as active. Therefore traders tend to offer lower prices for strip bonds on the secondary market, as they may have more difficulty reselling the strip bond to another investor.
- If you sell before maturity, you may have a capital loss, depending on market conditions at the time
- If interest rates (yields on bonds) have risen since the time you purchased the strip bond, it is possible that you would receive less than you paid (plus any interest you earned on the strip bond since the purchase)
- Tax laws may require that you pay taxes related to the hypothetical interest or gain each year, even if you did not receive an actual cash payment
- Since you do not receive annual payments on strip bonds, you may have to use other funds to pay the taxes each year.
- Because many strip bonds have a long time horizon, there could be unforeseen changes that adversely affect your investment (e.g., changes in tax laws, issuer credit rating, etc.)
- For example, the credit ratings on some sovereign issuers changed significantly in 2010 (e.g., Greece, Spain). This means that the price of any strip bonds for those governments would have fallen significantly as well.
Strip bond packages
Advantages
- Investment dealers can design packages to meet the needs of investors, so that the investor holds just one security instead of several strip bonds
- This means essentially that the investment dealer can create a custom bond to meet the needs of a group of investors, or even a single investor with a very large amount to invest.
- From a Canadian tax perspective, investors may realize some benefits in some circumstances
- As indicated above for strip bonds, the taxes for a strip bond package can be lower than for a conventional bond held in a taxable account.
Disadvantages
- Because the market for strip bond packages is very illiquid, you may not be able to sell them when you want to
- Strip bond packages are traded even less frequently than strip bonds. If a trader elects to break the package into the individual strip bonds, there are some costs involved in that. Accordingly, traders tend to discount the value of the packages when purchasing them in the secondary market.
- If you sell before maturity, you may have a capital loss, depending on market conditions at the time
- As for strip bonds, if interest rates (yields) rise, the value of your strip bond will fall, which could result in a capital loss
- Taxation of strip bond packages is much more complex than for conventional bonds or even strip bonds
- If holding a strip bond package in a taxable account, advice from a qualified tax practitioner is recommended.
- Tax laws may require that you pay taxes related to the hypothetical interest or gain each year, even if you did not receive an actual cash payment
- It is recommended that you maintain a spreadsheet showing the calculation of the accrued interest on the package for each year until maturity.
- Because many strip bond packages have a long time horizon, there could be unforeseen changes that adversely affect your investment (e.g., changes in tax laws, issuer credit rating, etc.)
- As indicated above for strip bonds, if the rating for the issuer behind the strip bond changes, the market value of the strip bond could fall.
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