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Strip bonds are fixed-income securities created when a financial institution separates a conventional bond into its individual cash flow components and sells each component separately as a zero-coupon security. Each stripped component pays no periodic interest. Instead, it is sold at a discount to its face value and matures at face value on a specific future date. The investor's return is the difference between the purchase price and the face value received at maturity. The term is especially common in Canada; the equivalent U.S. instrument is called a STRIP, which stands for Separate Trading of Registered Interest and Principal of Securities.
Think of a strip bond like buying individual pages of a book for their future resale value, rather than buying the whole book and reading it as you go.
An investment dealer purchases a regular coupon-bearing bond and deposits it with a custodian. The custodian then issues separate zero-coupon securities, each representing one future cash flow from the original bond. A 10-year bond paying interest semi-annually generates 20 interest payment strips plus one residual strip representing the return of principal at maturity. Each of these 21 strips is then sold to investors independently.
The interest payment strips are called coupon strips. The stripped principal component is called the residual. Both are zero-coupon instruments: they pay nothing until their specific maturity date, at which point they pay their full face value.
Because strip bonds pay nothing until maturity, their price is calculated as the present value of the single future payment, discounted at the prevailing yield for that maturity. A 10-year strip bond with a face value of $10,000 might sell for $6,000 today if prevailing yields are approximately 5.2%. The longer the term and the higher the prevailing yield, the deeper the discount. This sensitivity to interest rates also makes strip bonds highly sensitive to rate changes: a small change in yield produces a large change in price, a property measured by duration, which equals the term to maturity for a zero-coupon security.
In both the United States and Canada, investors owe income tax on the annual accrual of imputed interest in a strip bond even though no cash is received until maturity. This "phantom income" makes strip bonds inefficient in taxable accounts. They are best held in tax-deferred accounts such as registered retirement savings plans, registered retirement income funds, tax-free savings accounts, or registered education savings plans in Canada, and in IRAs or 401(k) plans in the United States.
Pension funds and insurance companies are major buyers of long-duration strip bonds because their duration closely matches long-term liabilities, a technique called asset-liability matching. Individual investors use them to lock in a known lump-sum value at a future date, making them useful for funding known future expenses such as a child's university tuition, a retirement income target, or a specific estate planning goal.
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