What is Coupon Stripping
Coupon stripping is the separation of a bond's periodic interest payments from its principal repayment obligation to create a series of individual securities. In coupon stripping, the underlying bond becomes a zero-coupon bond and each interest payment becomes a separate zero-coupon bond.
BREAKING DOWN Coupon Stripping
Coupon stripping is a structural technique which involves purchasing a bond and detaching its principal and interest components into individual securities that can be sold independently. The bond is repackaged into a number of zero-coupon or strip securities with varying maturity dates. The securitization of a bond’s interest payment coupons would be economically worthwhile if it results in the sum of the parts being larger than the whole. In contrast, if the proceeds from stripping turn out to be the same as the cost of purchasing the bonds then coupon stripping would be uneconomic.
Each coupon payment entitles its holder to a specified cash return on a specific date. In addition, the body of the security calls for repayment of the principal amount at maturity. For example, if an investment bank held a $50 million Treasury note that paid 5% interest annually for five years, coupon stripping would turn that bond into six new zero-coupon bonds – one $50 million bond that matures in five years and five $2.5 million (5% x $50 million) bonds that would each mature in one of the coming five years. Each bond will sell at a different discount to face value based on its time to maturity.
The market price of a strip bond reflects the issuer’s credit rating and the present value of the maturity amount which is determined by the time to maturity and the prevailing interest rates in the economy. The farther away the maturity date, the lower the present value, and vice versa. The lower the interest rates in the economy, the higher the present value of the zero-coupon bond, and vice versa. The present value of the bond will fluctuate widely with changes in prevailing interest rates since there are no regular interest payments to stabilize the value. As a result, the impact of interest rate fluctuations on strip bonds, known as the bond duration, is higher than the impact on periodic coupon-paying bonds.
Coupon stripping can also divide up a larger bond with a particular interest rate into a series of smaller bonds with different interest rates to satisfy investors' demands for particular types of bonds. This practice is seen in the mortgage-backed security (MBS) market.
The zero-coupon bonds created from coupon stripping make no periodic interest payments to investors. The bondholder receives a payment at maturity. The spread between the purchase price and the par value at maturity represents the return earned on the investment. If the security is held to maturity, the return earned is taxable as interest income. Even though the bondholder does not receive interest income, s/he is still required to report the 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.