Why do investors buy strip bonds?
There are many different reasons that investors may choose to purchase strip bonds. The most common of these are listed below.
- to reduce re-investment risk
Because there are no interest payments to be re-invested at future interest rates, the return on strip bonds is fixed at the time of purchase. This makes strip bonds suitable where a fixed amount is required on a known future date.
- as substitutes for T-bills
In Canada, more than 16% ($8.5 billion) of the face value in Government of Canada book-entry strips outstanding as of July 31, 2001 matured by the end of 2002, according to statistics previously published by CDS.
- as substitutes for guaranteed investment certificates (GICs) and term deposits
Of the $169 billion in face value outstanding in Canada as of July 31, 2001, approximately $48 billion (29%) will have matured by July 31, 2006, according to CDS. This compares to $365 billion in fixed term deposits that Canadian banks had outstanding as of July 2001, according to Bank of Canada statistics.
In Canada, GICs may have a government guarantee of payment, subject to a maximum that varies by the jurisdiction involved. There are no such limits on the interest and principal payments on the bonds, most of which are government issuers. In some cases, the issuers' payments are backed in full by a government guarantee (e.g., Ontario Hydro).
Strip bonds have an advantage over most GICs and term deposits, as they may be traded or sold prior to maturity to realize a capital gain or to have access to the funds.
- as long-term "GICs" with interest compounded
For strips, terms of five to 30 years (or more) are available. GICs and term deposits available through banks and trust companies are normally not available for terms exceeding five to 10 years.
- to match future obligations
Future obligations to make a lump-sum payment can be offset by purchasing strip bonds. With strip bonds, this matching can be much closer than with normal bonds.
For an example of how this is being 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.
- as a trading instrument
Trading strategies based on anticipated movements in yield curves or changes in the spreads between yield curves are sometimes applied to strip bonds. In addition, other strategies are being applied involving:
- creating strip bonds from original-issue securities or packages,
- reconstituting original-issue securities, and
- creating packages.
These strategies are based on the arbitrage between the strip bond market and the underlying bond market. Generally, this results in the bond market pricing bonds based on the present value of the cash flows.
- to minimize taxes on a bond portfolio
Choosing a strip bond can have favourable tax consequences for some investors in some jurisdictions. For example, in Canada, a taxable individual investor can choose between a bond and a series of strip bonds from that same bond. Assume that the bond pays 10% per year, with a current yield of 6%, and that the strip bonds yield 6% to maturity.
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 bonds, she pays tax every year only on the 6% yield to maturity. 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).
NOTE: Most strip bond issues, other than principal components, are relatively illiquid. Therefore you should be prepared to hold them to maturity. That being said, there are some interest components in Canada and the United States that now are fairly large, topping $1,000,000,000 in face value, which are more liquid.
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 