
Strip Bonds
A strip bond is a debt instrument in which both the principal and regular coupon payments — which have been removed — are sold separately. Their return at maturity will, therefore, be $100 - $64 = $36. 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. A conventional bond, also known as a coupon bond, is one that makes regular interest payments to bondholders who receive repayment for their principal investment when the bond matures. 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. 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.

What Is a Strip Bond?
A strip bond is a debt instrument in which 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.




How a Strip Bond Works
A conventional bond, also known as a coupon 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 then becomes known as the residue. The coupons and residue create a supply of new strip bonds which are sold to investors. A strip bond has no reinvestment risk because there are no payments before maturity.
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 five years. At maturity, the return on the strip bond residual will be $5,000 - $3,200, or $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 payments. 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. Their return at maturity will, therefore, be $100 - $64 = $36.
How Strip Bonds Are Priced
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.
Because holders of strips don’t receive additional income through interest payments, strip bonds typically trade at a deep discount to par.
Special Considerations: Strip Bonds and Taxes
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.
Related terms:
At a Discount
"At a discount" is a phrase used to describe the practice of selling stocks, or other securities, below their current market value read more
At a Premium
At a premium is a phrase attached to a variety of situations where a current value or transactional value of an asset is above its fundamental value. read more
Bond Valuation
Bond valuation is a technique for determining the theoretical fair value of a particular bond. read more
Bond : Understanding What a Bond Is
A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. read more
Cost Basis
Cost basis is the original value of an asset for tax purposes, adjusted for stock splits, dividends and return of capital distributions. read more
Certificate Of Government Receipts (COUGRs)
Certificates of Government Receipts are one of several synthetic stripped Treasury securities. read more
Coupon Rate
A coupon rate is the yield paid by a fixed income security, which is the annual coupon payments divided by the bond's face or par value. read more
Coupon Stripping
Coupon stripping bifurcates a bond's interest payments from its principal repayment obligation to create a pair of securities. read more
Coupon
A coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value, also referred to as the "coupon rate." read more
Coupon Bond
A coupon bond is a debt obligation with coupons attached that represent semiannual interest payments, also known as a "bearer bond." read more