A strip bond is a bond where both the principal and regular coupon payments—which have been removed—are sold separately. A strip bond is also known as a zero-coupon bond.
Breaking Down a Strip Bond
A conventional bond is one that makes regular interest payments to bondholders who receive repayment for their principal investment when the bond matures. These investors receive interest income, known as coupons, from these bonds which may be purchased at par, at a discount, or at a premium. Not all bonds make interest payments, though. These bonds are referred to as strip bonds.
A strip bond has its coupons and principal stripped off and sold separately to investors as new securities. An investment bank or dealer will usually buy a debt instrument and "strip" it, separating the coupons from the principal amount, which is known as the residue. The coupons and residue create a supply of new strip bonds which are sold separately to investors. A strip bond has no reinvestment risk because there are no payments before maturity.
Because holders of strips don’t receive additional income through interest payments, strip bonds typically trade at a deep discount to par. 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 from 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 strip 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 a coupon bond.
On the maturity date, the investor is repaid an amount equal to the face value of the bond. The difference between the purchase price of the bond and the face value at maturity represents the investor’s return on the bond. For example, assume an investor purchased a bond residual today for $3,200. The bond has a face value of $5,000 and is set to mature in 5 years. At maturity, the return on the strip bond residual will be $5,000 - $3,200 = $1,800.
Let’s consider another investor that purchased the coupon, instead of the residual. The investor will receive one of the bond’s original semi-annual interest or coupon payment. If the coupon rate on the bond is 4%, the interest payment to be received twice (since it’s a semi-annual payment schedule) can be calculated as (4%/2) x $5,000 = $100. The investor will pay ($3,200/$5,000) x $100 = $64. Her return at maturity will, therefore, be $100 - $64 = $36.
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.