DEFINITION of 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.

The stripped yield is also called the sovereign yield.

BREAKING DOWN Stripped Yield

The stripped yield is the return on a bond component after subtracting the return on the equity or option component of the instrument from the market price.

Brady Bonds

Concerning Brady bonds, the stripped yield is the implied sovereign yield of a bond, or the theoretical yield of the non-collateralized portion of a bond. In short, the stripped yield is the yield to maturity (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 investing in a combination of high graded money market instruments, a zero-coupon bond, and cash flows from sovereign interest payments. The standard calculation of the YTM of this type of bond is a weighted-average of the risky yield of the sovereign cash flow payments and the riskless yield of the collateral. However, with a stripped yield, calculation of yield only applies to the cash flows which are sensitive to sovereign credit risk.

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 Brady 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.

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.

Preferred Shares

Investors that purchase preferred shares often buy these shares with implied accrued dividend. 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 the stripped yield.