What are STRIP Bonds?
STRIP is an acronym that is commonly used to denote Separate Trading of Registered Interest and Principal of securities. This is a complex-sounding term however, in reality, the meaning is quite simple. It is important to understand that when we buy a bond that pays regular coupon payments, we are actually buying the right to receive a series of cash flows. For instance, if we buy a 5-year bond that pays a semi-annual coupon, we are actually buying the right to receive coupon payments on ten separate occasions and also one principal payment. Hence, we are in fact, buying the right to receive eleven separate payments! The STRIP bonds convert this one single bond into eleven different securities. The method which is used to undertake this conversion as well as the benefits of doing so has been discussed in this article.
How do STRIP Bonds Work?
STRIP bonds are usually created from the securities which have been issued by the United States government. Generally, United States treasury securities which have a maturity of more than 10 years are eligible for conversion into STRIP securities.
STRIP bonds are created by investment banks and brokerage firms. These firms purchase securities from the government via book-entry receipts. This means that Treasury makes a book entry acknowledging that these firms own the underlying securities. However, the actual securities are not issued since till the payment is made to the government.
Based on these book receipts, the investment banks create a new special purpose vehicle. The investment banks then create separate securities based on the cash flow pattern of the bond. For instance, in the example mentioned above, the investment bank would create eleven different securities out of each five-year semi-annual bond. These securities are then sold as zero-coupon bonds to different investors. In effect, the cash flow from the same bond has been stripped and sold off to different investors.
Each of these eleven securities will be sold to different investors based on their discounted cash flow value. The cash flow value is arrived at considering the present interest rate in the market as well as the term to maturity. Since the securities are issued by the United States treasury, the credit risk is considered to be close to zero. The special purpose vehicle created by the investment bank makes payments to the investors as and when they receive payments from the treasury.
It is important to note that there is an active and liquid secondary market for STRIP securities. Hence, even though the bonds are zero-coupon, investors do not have to hold them till maturity. They can sell these bonds in the secondary market in order to liquidate their investment anytime they want to do so.
Advantages of Purchasing STRIP Securities
STRIP securities are highly popular amongst a wide variety of investors. This is because of certain advantages which are provided by these securities. Some of these advantages have been mentioned below:
- Lower Tenure: One of the problems with purchasing treasury securities is the long tenure. The huge lock-in period of these securities often dissuades investors from making investments in these securities. STRIP securities provide users with a wide variety of durations. Hence, investors can choose to invest in a security with a six-month maturity also! This lower tenure along with the fact that the cash flow is guaranteed by the United States treasury makes such assets lucrative.
- Lower Minimum Amount: Investors often need to have a large amount of money if they want to buy treasury securities. For instance, treasury securities are sold for a minimum value of $10000. Individual investors may not want to lock in $10000 with a single investment in treasuries. It is for this reason that many investors were not able to make investments. STRIP securities can be purchased for as little as a few hundred dollars. This feature makes it popular amongst investors who want a smaller ticket size.
- No Reinvestment Risk: Treasury bonds pay interest periodically. However, this interest then has to be reinvested till maturity in order to realize the same return throughout the life of the bond. It is possible that the interest rate may fall during the tenure of the bonds and the overall growth rate of the investor falls. In the case of STRIP securities, the investors invest in zero-coupon bonds. Since they know the investment value and the maturity value, their interest rate is fixed and hence they face no reinvestment risk if they hold the security until maturity.
- Tax Benefits: There are many types of STRIP securities that can be included in retirement plans. As per the current tax code, STRIP securities will be allowed to grow tax-free till retirement. Since a small portion of every investor's funds is attributed towards debt securities, there is always a large number of buyers for these STRIP securities.
The fact of the matter is that even though STRIP securities are issued by private entities, they are actually backed by the United States treasury. Hence, they have almost no default risk. Other factors such as tenure and ticket size are also favorable to small investors. This is what makes it such an attractive proposition for smaller investors.
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