Introduction

Investors have different investment options to choose from, each with its advantages and disadvantages. Fixed income investments like bonds are an excellent option for investors looking for regular income and relatively low-risk investments. Strip bonds, also known as zero-coupon bonds, are a type of fixed income investment that has gained popularity in recent years due to their unique characteristics. In this paper, we will explore the concept of strip bonds, how they work, the advantages of investing in them, and strategies for investment.

What Is A Strip Bond?

A strip bond is a type of bond that is created by separating the interest and principal components of a bond. A dealer or investment bank purchases a large value bond, typically a government bond, and then separates it into individual components. The principal component is sold as a separate bond, known as the strip bond, and the interest component is sold as a separate bond, known as a coupon bond. Strip bonds are also referred to as zero-coupon bonds because they do not make regular coupon payments like other bonds.

The dealer then sells the strip bonds to investors at a discounted price. The discount represents the interest that would have been paid if the bond had regular coupon payments. For example, if a bond with a face value of $100 and a coupon rate of 5% is sold as a strip bond, an investor may purchase it for $50. The investor will not receive any interest payments, but will receive the full face value of the bond when it matures.

How Do Strip Bonds Work?

Investors purchase strip bonds directly from the investment dealer as a zero-coupon bond. The dealer earns all the money they will ever earn directly at the initial sale, and this has a debt obligation to the public for the remaining term. As the dealer receives coupon payments, it can pay the face value of its outstanding debt, thus maturing investors’ strip bonds.

For example, let’s say an investor purchases a strip bond with a face value of $1,000 and a maturity date of 10 years. The dealer sells the bond to the investor for $500, representing a 50% discount. The investor holds the bond for 10 years, during which time they do not receive any coupon payments. However, when the bond matures, the investor will receive the full face value of $1,000. The dealer will use the coupon payments it receives from the issuer to pay the face value of the bond to the investor.

Why Buy Strip Bonds?

Strip bonds offer several advantages to investors, which make them an attractive investment option. Some of the advantages include:

Fixed Yield to Maturity: Strip bonds offer a fixed yield to maturity, which means investors know exactly what their investment will be worth when it matures. Unlike other bonds, investors do not have to reinvest or factor in interest rates, as they know their investment will mature at face value.

Substitute for Short Term Money Market Investments: Strip bonds can be used as a substitute for short-term money market investments, such as certificates of deposit (CDs) or treasury bills. Because strip bonds have a fixed yield to maturity, investors can use them to lock in a guaranteed return over a specific time frame.

Opportunity to Take Advantage of Unfavorable Market Conditions: Because the investment will always mature at face value, investors can take advantage of unfavorable market conditions when investing in long-term strips. For example, if interest rates are high, investors can purchase a strip bond at a discount and earn a higher yield than they would on a bond with a lower coupon rate.

Duration and Strip Bonds

Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is an important consideration when investing in fixed income securities like strip bonds. The duration of a strip bond is determined by its maturity date, the size of the discount at which it was sold, and the prevailing interest rates in the market. Generally, the longer the maturity of the strip bond, the higher its duration, which means that the bond’s price will be more sensitive to changes in interest rates.

Investors who are concerned about changes in interest rates can use duration as a guide when selecting strip bonds to invest in. If interest rates are expected to rise, an investor may want to select a strip bond with a shorter duration. Shorter duration strip bonds are less sensitive to changes in interest rates, and therefore, have less price risk. On the other hand, if interest rates are expected to decline, an investor may want to select a strip bond with a longer duration. Longer duration strip bonds are more sensitive to changes in interest rates, and therefore, have more price risk.

Duration on a strip bond is measured directly in years to maturity. Because there is no coupon payment, investors interest rate risk is directly related to time-to-maturity. Therefore, if a zero coupon bond has two years to maturity, the duration is calculated to be equal to two.

Investors can use duration to calculate the unanticipated yield change of their strips during rate hikes/cuts with the following formula:

Ru = -D△i

Where:

• Ru: The unanticipated change in yield due to external interest rate changes.
• D: Duration of bond
• △i: change in interest rates

Investment Strategies for Strip Bonds

There are several investment strategies that investors can use when investing in strip bonds. The following are some of the most common strategies:

Laddering: Laddering involves purchasing multiple strip bonds with different maturities. This strategy helps to spread out the risk over a range of maturities and provides a steady stream of cash flows as the bonds mature. For example, an investor may purchase strip bonds with maturities of 1, 5, and 10 years. As each bond matures, the investor can reinvest the proceeds in new strip bonds with a similar maturity.

Barbelling: Barbelling involves investing in strip bonds with both short and long maturities, while avoiding intermediate maturities. This strategy is useful when an investor expects interest rates to either rise or fall significantly. Short-term strip bonds will benefit if interest rates rise, while long-term strip bonds will benefit if interest rates fall.

Bullet Strategy: The bullet strategy involves investing in a single strip bond with a specific maturity date. This strategy is useful for investors who have a specific financial goal, such as saving for a child’s college education or a down payment on a home.

Buy and Hold Strategy: The buy and hold strategy involves purchasing strip bonds with long maturities and holding them until maturity. This strategy is useful for investors who are looking for a steady stream of income over a long period of time and are not concerned about fluctuations in interest rates.

Conclusion

In conclusion, strip bonds are a unique type of fixed income investment that offer several advantages to investors. By purchasing strip bonds, investors can lock in a fixed yield to maturity, use them as a substitute for short-term money market investments, and take advantage of unfavorable market conditions when investing in long-term strips. Duration is an important consideration when investing in strip bonds, as it determines the bond’s sensitivity to changes in interest rates. Finally, there are several investment strategies that investors can use when investing in strip bonds, including laddering, barbelling, bullet strategy, and buy and hold strategy. As with any investment, it is important for investors to carefully consider their financial goals and risk tolerance before investing in strip bonds.