Strip Bond

In investing, bonds serve a central function as a safe haven for steady returns. Everywhere on earth, they are considered one of the safest options within the investment spectrum, especially for investors looking for fixed-income opportunities. Bonds- the loans actually made by investors to entities such as governments or corporations- pay back principle along with interest over a predetermined period. While most bonds have a similar design, strip bonds are a bit special in their setup; this catches the eye of certain investors who seek long-term employment. 

The article will delve further into the world of strip bonds: what they are, how they work, the kinds that exist, and some possible advantages and disadvantages for the investor. By the end, you’ll have a sense of whether strip bonds might be the right addition to your portfolio. 

What is a Strip Bond? 

A strip bond, also known as a zero-coupon bond, is a type of bond where the interest payments (or coupons) are separated from the principal amount. Unlike traditional bonds, strip bonds do not offer regular interest payments to the bondholder. Instead, they are sold at a discounted price, and investors receive a lump sum at maturity. The return comes from the difference between the bond’s purchase price and the face value, or maturity value. 

Since strip bonds do not provide periodic interest payments, they can be seen as a predictable investment, often appealing to those with long-term financial goals like retirement planning or education funding. 

Understanding Strip Bonds 

Understanding the formation process helps in better apprehending strip bonds. Strip bonds result from the traditional bonds, whose interest and principal payments are separated or ‘stripped’ from each other. This results in two different financial instruments: one is that of interest payments, while the other is the principle. Each one of them is sold as strip bonds individually. 

For instance, a bond that offers ten annual coupon payments along with a principal repayment can be stripped into 11 individual securities: 10 strips for the coupon payments and one strip for the principal. Investors can purchase each of these individually, giving them control over which part of the bond they wish to hold. 

Strip bonds are popular among long-term investors because they provide a known lump sum at a specific future date. Investors purchase these bonds at a discount and wait for the maturity date when they will receive the bond’s face value without the distraction of reinvesting regular interest payments.

Types of Strip Bonds 

There are different types of strip bonds based on the source from which they are derived: 

• Government Strip Bonds: These are created by stripping government-issued bonds. In countries like the US and Singapore, governments issue bonds that can be stripped into individual securities. For example, the US Treasury issues strip bonds called Treasury STRIPS (Separate Trading of Registered Interest and Principle of Securities). 

• Corporate Strip Bonds: Corporate bonds can also be stripped, meaning companies can issue bonds where the coupons and principle can be separated and sold as individual securities. These are generally considered higher risk compared to government strip bonds due to the potential credit risk associated with corporations. 

• Synthetic Strip Bonds: Some financial institutions may create synthetic strip bonds by purchasing regular bonds and stripping the coupons from the principle. These synthetic bonds function in the same way as government or corporate strip bonds but are created by private entities. 

How Strip Bonds Work 

The process of creating and trading strip bonds is fairly straightforward. A financial institution, for example, a brokerage firm, takes a regular bond and separates its coupon payments from the principal. These stripped pieces are then sold to investors as individual strip bonds. 

For example, suppose an investor buys a strip bond that will pay US$50,000 at maturity in 10 years. The investor will pay a discounted amount, such as US$40,000 today, and in 10 years, they will receive the full US$50,000. Since there are no periodic interest payments, the return on the investment comes from the appreciation of the bond’s value over time. 

Strip bonds work well for investors who want a known payout at a future date without needing to manage periodic cash flow. 

Examples of Strip Bonds 

One of the most well-known examples of strip bonds is Treasury STRIPS in the United States. As in the case of the US Treasury, traditional bonds are also later stripped into separate securities of interest and principal and traded as such. Treasury STRIPS tend to enjoy significant popularity among low-risk, long-term investors. 

Hence, in Singapore, Singapore Government Securities may be stripped and traded as individual bonds.These bonds are ideal for investors seeking guaranteed returns with minimal risk. 

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