Strip Bonds Information Centre

Risk considerations

There are several risks that should be considered when investing in strip bonds and strip bond packages. The risks listed here include those that must be disclosed in Canada plus some additional risks that I believe should be considered. This list should not be considered to be exhaustive. The current version of the disclosure document used by Canadian investment dealers is available on the IDA web site.

Price volatility

Price volatility is the risk that is most frequently mentioned when purchasing strip bonds. This simply means that, for a given change in interest rates, the price of the strip bonds will move more (as a percentage of the market value) than would the price of a conventional bond.

See Price volatility for more details.

Liquidity

Liquidity in the strip bond markets varies widely, but will tend to be lower than liquidity for conventional bonds having the same issuer. Relatively few strip bonds have large amounts outstanding (e.g., over $100,000,000 USD). Usually these are the principal components (residuals).

In Canada and the U.S., some interest components (coupons) also are quite large. In Canada, because of the broader eligibility for stripping, most strip bonds have small outstanding amounts, with some being less than $10,000. Strip bond packages in Canada also tend to have small outstanding amounts. Strip bond and strip bond package issues with small amounts outstanding normally will have low liquidity.

If the liquidity is low, it may be difficult to sell the securities. There also may be a large difference between the bid and ask prices.

In most countries, the total face value of each strip bond can be calculated by using the statistics that are published. In the U.S. and Canada, this is more difficult because of the larger number of bonds involved.

In Canada, the amounts can be calculated for the bonds that were stripped by book-entry, although the calculation will be quite time-consuming since there are more than 400 bonds involved. However, to get the most accurate results, you have to adjust for physical strip bonds. The only way to get this information currently is to subscribe to monthly reports offered by CDS. These reports provide the total face value on deposit in each strip bond, as well as the face value that has been used to create strip bond packages or synthetically reconstitute bonds.

NOTE: Since almost all of the bonds that were physically stripped in Canada have now matured, or will mature by 2015, this adjustment usually will not be significant now.

Credit risk of the issuer

The strip bonds and strip bond packages that are derived from underlying bonds are subject to the credit worthiness of the issuer of the underlying bond(s) involved. A change in the opinion of investors and/or credit rating agencies of the credit worthiness of any issuer may affect the market price of the related strip bonds and strip bond packages.

If the issuer of an underlying security becomes the subject of insolvency proceedings of any kind, there is a risk that payments due on the related strip bonds and strip bond packages may not be received in full (if received at all) or may be significantly delayed. Investors may want to inquire about the policies and procedures for handling these situations in the markets in which they invest.

For corporate issuers, the arrangements governing the creation of strip bonds should be examined very carefully to ensure that investors have reasonable protection in the event of a default. This becomes even more crucial if generic strip bonds are used.

If the credit worthiness of an issuer declines, the potential negative impact on the related strip bonds and strip bond packages may be greater than the impact on conventional bonds because of the greater price volatility of the strip bonds and strip bond packages and the less liquid market for strip bonds and strip bond packages.

Investors in some European strip bonds might recall that the credit ratings of some government issuers were downgraded with the conversion to the Euro.

Custodian risk considerations

Where the strip bonds are created through a strip bond service not operated or managed by the underlying issuer or their agent, there is always a potential risk, however slight, of the entitlement payments not being received. For services operated by a recognized securities depository, usually the federal government and/or central bank may have reviewed the systems, procedures, and controls of the service, to some degree. However, they may not necessarily have formally approved the arrangements.

For these services, due to the extensive risk controls that the securities depositories maintain routinely, the risk of not receiving the entitlement from the depository is probably very low, provided that the issuer of the underlying bond makes the payment to the depository.

Some depositories, such as CDS, publish an annual report on their internal controls and safeguards. If a report of this nature is publicly available, you may wish to review the following topics:

This information will give you a reasonable idea of the current and historical controls only. When reviewing this information, it may be worthwhile to compare the current report to earlier versions, to identify changes. For example, the 2003 CDS risk report updated the controls on CDS book-entry strip bonds, to reflect the 2002 changes in the custody of physical strip bonds.

Where the strip bonds are created as receipt securities through (or held in certificate form by) a custodian bank or trust company, there is a slightly higher risk that the payments may be delayed or not received, depending on the particular bank or trust company. For these institutions, you may wish to consider the same points outlined previously for securities depositories. Note that this information may not be as readily available for these institutions, as the custody of securities typically will not be the primary business of the institution.

For receipt security strip bonds created through a custodian, there also is the risk that the custodian bank or trust company could sell its custody and/or transfer agent business to another organization at some point prior to the maturity of the strip bonds. In this case, if you hold the securities registered in your own name, the custodian may send you notification of the change. To ensure that you receive any such notices, you must always notify the custodian of any changes in your mailing address. If you do not do so, and there is either a change in the custodian or a fundamental change affecting the underlying security, you could easily miss receiving the notice.

If you hold any type of strip bonds through a financial institution, the institution normally will assume the responsibility of notifying you if there are any significant changes that affect your rights as a holder.

Currency risk

If the strip bond or strip bond package pays in a currency other than your local currency, then you have the potential for extra gains if your local currency has gone down relative to the currency of the strip bond or strip bond package. If your local currency has made gains in the currency market, then the value of your investment will go down, possibly resulting in a loss.

Debt restructuring risk

If an issuer decides to restructure their debt for any reason, there is a risk that you may get your money back earlier than planned. Depending on the terms of the restructuring, you may get back either more or less than the market value of the strips prior to the restructuring announcement.

A good example of this is the Bell restructuring that was proposed in Canada, where most of the bonds were expected to be redeemed will receive less than the market value at the time of the announcement, and some of those issues had been stripped.

For government issuers, examples of the debt being restructured would include several European nations converting their debt to Euros. In this case, the investors were not adversely impacted. However, other countries have restructured their debt in the past for other reasons, sometimes with negative impacts on their bondholders.

International securities risk

Investing in strip bonds of issuers based in other countries involves considerations and possible risks not typically involved in investing in securities of issuers based in your own country, including potential instability of some international governments, the possibility of expropriation, limitations on the use or removal of funds or other assets, changes in governmental administration or economic or monetary policy (in your own country or abroad) or changed circumstances in dealings between nations. The application of international tax laws (for example, the imposition of withholding taxes on dividends, interest payments or capital gains) or confiscatory taxation may also affect investments in international securities. Higher expenses may result from investments in international securities than would be the case for investments in domestic securities because of costs incurred in connection with conversions between various currencies and higher international brokerage commissions and custody costs. International securities markets also may have differences in liquidity, volatility, and government supervision. Other factors to consider include potential differences in accounting, auditing, and financial reporting standards and potential difficulties in enforcing contractual obligations in another country.

Government policies risk

Because of the long-term nature of many strip bonds (up to 99 years in Canada), there is a potential for changes in government taxation policies to affect your return on investment. For example, Canada once allowed the first $1,000 of interest income to be tax-free. Now, all interest income is subject to normal tax rates.

Custodial cost risk

Increasingly investment dealers and others have been increasing their fees and introducing new fees to cover their costs. Since strip bonds and strip bond packages are book-entry only securities now, investors holding these securities must hold them through a financial institution until maturity, which could be many years in the future. If the financial institutions were to introduce a new fee for accounts holding strip bonds (e.g. for inactive accounts), investors may have to either pay the fee or shop for another financial institution and possibly pay a fee for transferring their account.

Legal risk

Some countries adopted legislation and/or regulation changes to provide investors with assurance that the strip bonds created from federal government bonds would be considered to be direct obligations of the national government. Other countries, such as Canada, rely on contractual arrangements between the central securities depository and the participants in the depository.

Where the depository uses contracts, investors may wish to inquire into the details of the arrangement and satisfy themselves that the terms affecting the investors cannot be easily changed without the approval of the strip bond holders, in addition to any other required approvals for changes. Administrative changes, such as procedures to be followed by the depository participants, should require only the approval of the depository and its participants, and approval (or "non-disapproval") of the appropriate regulators.

See the Special Situations section in Entitlements for additional information related to legal risks.



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