What Is a Stripped Yield?
Stripped yield is a measure of the non-collateralized, independent return of a bond or warrant after all the monetary incentives and features have been removed. Stripped yields measures the return on only the debt portion of a bond or warrant, and so removes the impact of any embedded options, or conversion rights, or accrued interest.
- The stripped yield of a fixed-income security removes the value of all embedded options, rights, and other incentives from consideration.
- As such, the stripped yield only considers the credit aspect of a bond or other fixed-income instrument.
- The stripped yield is called the sovereign yield when it applies to government debt securities such as Brady bonds.
Understanding Stripped Yield
Many fixed-income securities come with embedded features such as convertible bonds, which grant the holder the right to convert their bonds into shares, putable (retractible) bonds that allow creditors to demand full repayment early, or callable bonds that can be redeemed by the issuer prior to maturity. The stripped yield is the return on the bond component after subtracting any value or return related to the equity, warrant, or option component of the instrument from the market price.
By removing additional interest features, investors can determine meaningful comparisons between convertible and non-convertible securities and debt instruments. For example, by removing the built-in interest features and principal guarantees present in old Brady bonds, investors are able to evaluate the sovereign risk associated with the bonds should there be a default on the part of the issuing nation. Evaluating the stripped yield is also helpful in assessing many of today's debt securities, which feature embedded call options, "stepped" (increasing) coupons and the like.
The stripped yield is calculated by stripping away the collateral component of the bond. To calculate the stripped yield, first price the principal component of the bond in terms of the value of a U.S. zero coupon with a similar maturity. This is done by discounting the value of the collateral cash flows at the U.S. Treasury rate. Subtract this price from the price of the Brady bond to get the price of the sovereign cash flows and, lastly, use the derived price to calculate the yield.
Brady Bonds and Sovereign Yield
Brady bonds are sovereign debt securities, denominated in U.S. dollars (USD), issued by developing countries and backed by U.S. Treasury bonds. Here, the stripped yield is the implied sovereign yield of the bond, or the theoretical yield of its non-collateralized portion. In short, the stripped yield is the YTM on sovereign risk cash flows. The semi-annual coupon payments on Brady bonds are collateralized with money market securities, while the principal payments due on the maturity date of the bond are collateralized with U.S. Treasury zero-coupon bonds.
An investor who purchases this bond is effectively buying a combination including a high-grade money market instrument, a zero-coupon bond, and the stripped cash flows from sovereign interest payments. The calculation of the yield to maturity (YTM) of this type of bond only applies to the cash flows which are sensitive to sovereign credit risk.
The difference between the stripped yield and the U.S. Treasury yield is called the stripped yield spread. The stripped spread is viewed as a better indicator of the creditworthiness of the Brady issuer than the yield-to-maturity spread commonly used in contrasting U.S. corporate issues with Treasuries.
Stripped Yield and Preferred Shares
Investors that purchase preferred shares often buy these shares with implied accrued dividend, and so a stripped yield is often more appropriate for understanding the true value of the preferred. The number of days interest earned on the preferred shares from the day the last dividend was paid to the day the shares are purchased represents the accrued dividend.
For example, assume a preferred share is trading for $40 and paying 5% dividend. The dividend dollar amount, thus, is 5% x $40 = $2 per share per year. An investor purchases the shares at a time when the last dividend payment was 90 days prior. The accrued dividend can be calculated as $2/365 x 90 = $0.49.
To find the price of the pure debt portion of the security, the accrued dividend is subtracted from the market price of the preferred share. In other words, the dividend rights are stripped away from the preferred share, separating ownership between the stock and any dividend on the stock that has not become payable. In our example above, the stripped price of the preferred stock is $40 – $0.49 = $39.51.
The stripped yield is the annual dollar dividend of a preferred stock divided by its stripped price. Continuing with our example, $2/$39.51 = 5.06% is thus the stripped yield.