Strip Bonds
What Is a Strip Bond?
A strip bond is a debt instrument in which both the principal and customary coupon payments — which have been taken out — are sold separately. A strip bond is otherwise called a zero-coupon bond.
How a Strip Bond Works
A conventional bond, otherwise called a coupon bond, is one that causes ordinary interest payments to bondholders who to receive repayment for their principal investment when the bond matures. These investors receive interest income, known as coupons, from these bonds which might be purchased at par, at a discount, or at a premium.
However, not all bonds make interest payments. These bonds are alluded to as strip bonds. A strip bond has its coupons and principal stripped off and sold separately to investors as new securities.
An investment bank or dealer will as a rule buy a debt instrument and "strip" it, separating the coupons from the principal amount, which then, at that point, becomes known as the residue. The coupons and residue make a supply of new strip bonds which are sold to investors. A strip bond has no reinvestment risk in light of the fact that there are no payments before maturity.
On the maturity date, the investor is reimbursed an amount equivalent to the face value of the bond. The difference between the purchase price of the bond and the face value at maturity addresses the investor's return on the bond. For instance, expect an investor purchased a bond residual today for $3,200. The bond has a face value of $5,000 and is set to mature in five years. At maturity, the return on the strip bond residual will be $5,000 - $3,200, or $1,800.
We should think about one more investor that purchased the coupon, rather than the residual. The investor will receive one of the bond's original semi-annual interest or coupon payments. If the coupon rate on the bond is 4%, the interest payment to be received two times (since it's a semi-annual payment schedule) can be calculated as (4% \u00f7 2) x $5,000 = $100. The investor will pay ($3,200 \u00f7 $5,000) x $100 = $64. Their return at maturity will, consequently, be $100 - $64 = $36.
How Strip Bonds Are Priced
The market price of a strip bond mirrors the backer's credit rating and the current value of the maturity amount, not entirely set in stone when to maturity and the overarching 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 strip bond, and vice versa. The current value of the bond will vacillate widely with changes in winning interest rates since there are no customary interest payments to balance out the value. Thus, the impact of interest rate changes on strip bonds, known as the bond duration, is higher than the impact on a coupon bond.
Since holders of strips don't receive extra income through interest payments, strip bonds normally trade at a deep discount to par.
Special Considerations: Strip Bonds and Taxes
In the event that the bond 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 phantom or 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. On the off chance that the bond is sold before it matures, a capital gain or loss might follow.
Features
- A strip bond is a debt obligation whose principal and coupon payments are taken out (or stripped) by investment firms or dealers and sold separately to investors.
- An investor who purchases the coupons receives the interest they pay on the bond's maturity date.
- Since no payments are made before maturity, a strip bond has no reinvestment risk.
- An investor who buys the separated principal from the bond, known as the residue, receives an amount equivalent to the face value of the bond when it matures.
