Why do investors buy strip bond packages?
- as substitutes for bonds
Two of the first large-value packages in Canada were structured to make interest and principal payments just like a bond from the same issuer, but with coupon rates lower than those for conventional bonds with the same maturity date. This allowed investors to benefit from higher yields without facing a capital loss at maturity.
- as substitutes for GICs (Guaranteed Investment Certificates) and term deposits (paying periodic interest)
The cash flows for bond-type packages can be designed to be equivalent to those of a GIC paying interest annually, semi-annually, quarterly, or monthly. For packages created from government strip bonds, there are no limits on the payment amount guaranteed by that government.
- as long-term GICs (with periodic payments)
Strip bond packages are available with maturity dates more than 20 years in the future. Also, the cash flows can be designed so that the first periodic payments are deferred until the investor needs the money.
- as substitutes for annuities
Packages can be customized so that the cash flows are similar to those available from annuities. These packages can be created with or without a lump sum payment at maturity.
- to match future obligations
Future obligations to make periodic payments can be offset by purchasing packages.
For an example of how this could be used by charities, see Gifts of Stripped Bonds. This article explains how a church uses strip bonds to fund maintenance of their building 10 to 20 years in the future. Instead of using individual strip bonds maturing each year, they could buy a strip bond package that gives them the same dollar amount every year for, say, 10 years.
- as trading instruments
For packages, most trading strategies used to date involve creating packages from strip bonds, or separating packages into strip bonds.
- to minimize taxes on a bond portfolio
Choosing a strip bond package can have favourable tax consequences for some investors. For example, a taxable individual investor can choose between a bond and a strip bond package composed of the strip bonds from that same bond. Assume that both the bond and the package pay 10% per year and that the current yield is 6% on both.
If the investor chooses the bond, she pays tax on that 10% every year (as interest income), but will have a capital loss when the bond matures. The loss can only be used to offset taxable capital gains. If the investor has no such gains, then the capital loss is of no value.
If the investor chooses the strip bond package, she pays tax every year only on the 6% yield to maturity, since the strip bond package is taxed on the same basis as strip bonds (based on the original yield). At maturity, there is no capital loss that can be claimed.
The net result is that the investor realizes a small savings in taxes for the life of the investment. Before using this type of strategy, investors should consult a registered investment advisor. You should also consider the potential additional commissions that you may be charged (either directly or included in the quoted price) for this type of transaction.
Most strip bond packages are quite small in terms of outstanding quantity and therefore are very illiquid if you want to sell them. If you buy a strip bond package, you should be prepared to hold it until maturity.
NextCopyright Keith Campbell ©2002-2007. All rights reserved.
, 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 book. He is a regular guest on ROBTV. Visit his web site 