A:

The quick answer to this question is that a stripped bond is a bond that has had its main components broken up into a zero-coupon bond and a series of coupons.

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 and 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.

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.

For further reading, see Advantages of Bonds and our tutorials Bond Basics Tutorial and Advanced Bond Concepts.

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