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:
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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