The quick answer to this question is that a stripped bond (or “strip bond“) is a bond that has had its main components broken up into a zero-coupon bond and a series of coupon payments.
Key Takeaways
- A stripped bond has had its principal and coupon payments bifurcated and sold separately to investors.
- The separated principal from the bond, known as the residue, becomes a zero-coupon bond that matures to face value.
- Even though the bondholder does not receive interest income, they are still required to report the imputed interest on the bond to the IRS.
Bond Basics
To help explain one, let’s first describe a bond. A bond is a debt instrument traditionally comprised of two parts, the face value (principal) and the coupons (interest rate). The face value of the bond is the amount received by the bondholder at maturity. The coupon refers to a fixed-interest payment made to the bondholder at predetermined intervals.
A stripped bond is a bond that has had its coupon payments and principal repayment “stripped” into two separate components that are then sold individually. One party will receive the principal at maturity (zero-coupon bond) and the other party will receive the fixed-interest payment over the life of the bond in the form of a stream of coupons.
Example of a Stripped Bond
Let’s take a look at a simplified stripped bond example. Suppose Cory’s Tequila Co. needs to raise capital to finance a new distillery. It decides the best way to do this is to issue bonds, which are sold with a face value of $1,000, a coupon payment of 5% paid annually, and matures in five years.
Ben’s Investment Co. is in the business of bond stripping and buys the bond for $1,000 and then strips out the coupons. If Ben’s sells the principal-stripped bond for $800 to an investor and the coupon payments for $200 to another investor, the $200 and the $800 received will make Ben’s break even on the purchase of the bond. The individual with the coupon-stripped bond will get the par value of $1,000 at the end of the five years from Cory’s Tequila Co, making a profit of $200. And the purchaser of the coupons will pay $200 to receive $250, meaning they make $50 off the purchase. By providing this investment service, Ben’s would receive a commission on the sale of these two stripped bonds.
Note
The end result of a stripped bond is the same end result as a “normal” bond; it’s just that the return may be shared among two investors.
Advantages of Stripped Bonds
Here are reasons why an investor might choose a stripped bond, each explained in a paragraph:
- Elimination of Reinvestment Risk: In traditional bonds, coupon payments are made periodically, and investors must reinvest those payments at prevailing interest rates, which could be lower than the bond’s initial yield. With stripped bonds, if you only hold the principal portion, there are no periodic interest payments. The bond is purchased at a discount and pays out its full face value at maturity. This structure ensures that the investor locks in a fixed return without the uncertainty of future reinvestment rates.
- Potential for Higher Yields: Investors may be attracted to stripped bonds because they can offer higher yields compared to regular coupon-paying bonds, especially in a stable or declining interest rate environment. Since stripped bonds are sold at a deep discount, the yield is the difference between the purchase price and the face value at maturity. For long-term investors, this can translate into significant returns if they are willing to hold the bond to its maturity date.
- Zero-Coupon Structure Benefits: The zero-coupon structure of stripped bonds makes them highly sensitive to interest rate changes. As interest rates fall, the value of stripped bonds tends to increase more sharply than traditional bonds due to the lack of periodic coupon payments.
- Matching Future Liabilities: Investors who need to match future liabilities, such as pension obligations or planned major expenses, may choose stripped bonds because they provide a known payout at a fixed date in the future. This can be true if the investor only cares to receive a certain amount of cash (i.e. only the principal or only the coupon payments) at any given time.
- Diversification of Fixed-Income Portfolio: Stripped bonds can be a diversifying tool as well. Including stripped bonds in a portfolio can help balance risk, particularly for investors seeking exposure to long-term fixed-income assets with a predictable outcome. For example, an investor may choose to invest in an equity security with a given fixed time horizon of success; they may choose to invest a small amount of capital into the coupon payments to hedge against this risk in the shorter term.
Risks of Stripped Bonds
One of the primary risks is interest rate sensitivity. Stripped bonds are zero-coupon securities, meaning they pay no periodic interest and are sold at a discount to their face value. As a result, their price is more sensitive to changes in interest rates compared to regular bonds. When interest rates rise, the value of a stripped bond can fall sharply.
Another significant risk is inflation risk. Since stripped bonds offer a fixed payout at maturity, their value does not adjust for inflation. Over time, rising inflation can erode the purchasing power of the lump-sum payment or coupon payments received at maturity. For long-term investors, this risk can be really high. For example, consider how bond investors in 2019 fared as interest rates rose in subsequent years.
Liquidity risk is another factor to consider with stripped bonds. While some stripped bonds, such as U.S. Treasury STRIPS, are relatively liquid, others may be harder to sell quickly at a fair price. The market is simply larger for “normal” bonds. Investors in stripped bonds also face tax complications. As mentioned below, there are some IRS considerations.
Lastly, as is the case for all bonds, stripped bonds carry default risk. While U.S. Treasury STRIPS are considered virtually risk-free due to the government’s backing, stripped bonds from other issuers may carry a higher risk of default, meaning the debt liability would never be paid back.
Special Considerations
There are additional factors to consider. The price which Ben’s Investment Co. can sell the face value of the bond will depend on the prevailing interest rates at the time of sale. It may also sell off the coupon payments to other investors. In the example, Ben’s breaks even and receives no return on its investment. Companies that do this make money based on selling at a premium to do the stripping service along with any gain it makes from the difference between the selling price on either the face value or coupon payments compared to what they initially paid for the bond.
If the bond is held to maturity, the return earned is taxable as interest income. Even though the bondholder does not receive interest income, they are still required to report the phantom or imputed interest on the bond to the Internal Revenue Service (IRS) each year. The amount of interest an investor must claim and pay taxes on a strip bond each year adds to the cost basis of the bond. If the bond is sold before it matures, a capital gain or loss may ensue.
What Is A Stripped Bond?
A stripped bond is a type of bond where the interest payments and the principal repayment are separated, or “stripped,” into individual securities.
How Does A Stripped Bond Work?
In a stripped bond, the future interest payments and the final principal repayment are sold separately. For example, a 10-year bond that pays interest semi-annually could be stripped into 21 individual zero-coupon securities: 20 for the interest payments and 1 for the principal. Each strip has its own maturity date, and the investor receives the full face value of each strip at that time without receiving interim coupon payments.
What Are The Two Components Of A Stripped Bond?
The two components of a stripped bond are the coupon strips and the principal strip. Coupon strips represent the periodic interest payments that were originally part of the bond, while the principal strip represents the bond’s face value, which is paid at maturity.
Why Would An Investor Choose A Stripped Bond?
Investors may choose stripped bonds for several reasons. One common motivation is the desire to eliminate reinvestment risk since stripped bonds do not pay periodic interest that would need to be reinvested at fluctuating rates. Additionally, stripped bonds, being zero-coupon securities, allow investors to purchase them at a deep discount and receive the face value at maturity.
The Bottom Line
Stripped bonds are zero-coupon securities created by separating a bond’s interest payments and principal repayment. This allows investors to purchase them at a discount and receive the full face value at maturity. This also allows investors to purchase the principal as well as the coupon separately.
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