- A stripped bond has had its principal and coupon payments bifurcated and sold separately to investors.
- The separated principal from the bond, known as the residue, becomes a zero-coupon bond that matures to face value.
- Even though the bondholder does not receive interest income, they are still required to report the imputed interest on the bond to the IRS.
To help explain one, let's first describe a bond. A bond is a debt instrument traditionally comprised of two parts, the face value (principal) and the coupons (interest rate). The face value of the bond is the amount received by the bondholder at maturity. The coupon refers to a fixed-interest payment made to the bondholder at predetermined intervals.
A stripped bond is a bond that has had its coupon payments and principal repayment "stripped" into two separate components that are then sold individually. One party will receive the principal at maturity (zero-coupon bond) and the other party will receive the fixed-interest payment over the life of the bond in the form of a stream of coupons.
Example of a Stripped Bond
Let's take a look at a simplified stripped bond example. Suppose Cory's Tequila Co. needs to raise capital to finance a new distillery. It decides the best way to do this is to issue bonds, which are sold with a face value of $1,000, a coupon payment of 5% paid annually, and matures in five years.
Ben's Investment Co. is in the business of bond stripping and buys the bond for $1,000 and then strips out the coupons. If Ben's sells the principal-stripped bond for $800 to an investor and the coupon payments for $200 to another investor, the $200 and the $800 received will make Ben's break even on the purchase of the bond. The individual with the coupon-stripped bond will get the par value of $1,000 at the end of the five years from Cory's Tequila Co, making a profit of $200. And the purchaser of the coupons will pay $200 to receive $250, meaning they make $50 off the purchase. By providing this investment service, Ben's would receive a commission on the sale of these two stripped bonds.
There are additional factors to consider. The price that Ben's Investment Co. can sell the face value of the bond will depend on the prevailing interest rates at the time of sale. It may also sell off the coupon payments to other investors. In the example, Ben's breaks even and receives no return on its investment. Companies that do this make money based on selling at a premium to do the stripping service along with any gain it makes from the difference between the selling price on either the face value or coupon payments compared to what they initially paid for the bond.
If the bond is held to maturity, the return earned is taxable as interest income. Even though the bondholder does not receive interest income, they are still required to report the phantom or imputed interest on the bond to the Internal Revenue Service (IRS) each year. The amount of interest an investor must claim and pay taxes on a strip bond each year adds to the cost basis of the bond. If the bond is sold before it matures, a capital gain or loss may ensue.