Coupon Stripping

What Is Coupon Stripping?

Coupon stripping is the separation of a straight bond's periodic interest payments from its principal repayment obligation to make a series of individual securities. In coupon stripping, the underlying bond turns into a zero-coupon bond known as a strip bond and each interest payment turns into its own separate zero-coupon bond.

How Coupon Stripping Works

Coupon stripping is a structural technique that includes purchasing a bond and disconnecting its principal and interest parts into individual securities that can be sold freely. The bond is repackaged into a number of zero-coupon or strip securities with changing maturity dates.

The securitization of a bond's interest payment coupons is beneficial when it brings about the sum of the parts being bigger than the whole. Interestingly, in the event that the proceeds from stripping end up being equivalent to the cost of purchasing the bonds then coupon stripping would be a losing proposition.

Every coupon payment qualifies its holder for a predetermined cash return on a specific date. Likewise, the body of the security calls for repayment of the principal amount at maturity.

The market price of a strip bond mirrors the backer's credit rating and the present value of the maturity amount not entirely settled when to maturity and the predominant interest rates in the economy. The farther away from the maturity date, the lower the current value, and vice versa. The lower the interest rates in the economy, the higher the current value of the zero-coupon bond, and vice versa.

The current value of the bond will vacillate widely with changes in winning interest rates since there are no ordinary interest payments to settle the value. Subsequently, the impact of interest rate changes on strip bonds, known as the bond duration, is higher than the impact on periodic coupon-paying bonds.

Model

Coupon stripping is common practice in U.S. Treasuries, where they are known by the abbreviation STRIPS (Separate Trading of Registered Interest and Principal of Securities).

For instance, in the event that an investment bank held a $50 million Treasury note that paid 5% interest every year for quite some time, coupon stripping would transform that bond into six new zero-coupon bonds — one $50 million bond that matures in five years and five $2.5 million (5% x $50 million) bonds that would each mature in one of the approaching five years. Each bond will sell at an alternate discount to face value in light of its chance to maturity.

Special Considerations

Coupon stripping can likewise split a bigger bond with a particular interest rate into a series of more modest bonds with various interest rates to fulfill investors' requests for particular types of bonds. This practice is found in the mortgage-backed security (MBS) market.

The zero-coupon bonds made from coupon stripping make no periodic interest payments to investors. The bondholder receives a payment at maturity. The spread between the purchase price and the par value at maturity addresses the return earned on the investment. In the event that the security is held to maturity, the return earned is taxable as interest income.

Even however the bondholder doesn't receive interest income, they are as yet required to report the imputed interest on the bond to the Internal Revenue Service (IRS) every year. The amount of interest an investor must claim and pay taxes on a strip bond every year adds to the cost basis of the bond. In the event that the bond is sold before it matures, a capital gain or loss might follow.

Features

• Since interest payments are not made on the strip bond before maturity, there is no reinvestment risk.
• For tax purposes, the IRS treats the value earned at maturity on a strip bond as earned interest.
• Coupon stripping bifurcates the coupon interest and principal repayment highlights of a bond, making two individual securities that both function as zero-coupon bonds.
• Stripping coupons from U.S. Treasuries makes STRIPS, or Separate Trading of Registered Interest and Principal of Securities.