Stripped bond

3 key takeaways

• Stripped bonds separate the interest and principal payments of a bond, creating zero-coupon bonds.
• They provide investors with fixed, predictable payments at maturity.
• These bonds can be useful for matching future liabilities, such as retirement income.

What is a stripped bond?

A stripped bond, also known as a zero-coupon bond, is a type of bond that has been separated into its individual interest (coupon) and principal (face value) components. These components are then sold separately to investors as two distinct securities. This process is often referred to as “stripping” the bond.

In a typical bond, the investor receives periodic interest payments (coupons) and the principal amount at maturity. However, with stripped bonds, the interest payments and principal repayment are sold separately as zero-coupon securities. Each stripped bond is sold at a discount to its face value and does not pay periodic interest. Instead, the investor receives a lump sum payment at maturity.

Benefits and risks of stripped bonds

Stripped bonds offer several advantages to investors, particularly those seeking fixed, predictable payments in the future.

• Fixed payments: Stripped bonds provide a fixed amount at maturity, which can help investors plan for specific future financial needs, such as retirement income or college tuition.
• Price predictability: Since stripped bonds do not pay periodic interest, their prices are less sensitive to interest rate fluctuations compared to regular bonds.
• Tax advantages: In some jurisdictions, the interest accrued on stripped bonds may be taxed differently, potentially offering tax benefits to certain investors.

While stripped bonds offer benefits, they also come with certain risks that investors should consider.

• Interest rate risk: Although less sensitive than regular bonds, stripped bonds are still affected by changes in interest rates. Rising rates can decrease the present value of the future payment.
• Reinvestment risk: Since stripped bonds do not pay periodic interest, investors do not have the opportunity to reinvest the interest payments at potentially higher rates.
• Liquidity risk: Stripped bonds may be less liquid than traditional bonds, making it more difficult to sell them quickly at a fair price.

Uses of stripped bonds

Stripped bonds are often used in financial planning and investment strategies where predictable future cash flows are required. They are particularly useful for:

• Matching future liabilities: Investors can use stripped bonds to match future financial obligations, such as pension payouts or insurance liabilities.
• Investment diversification: Including stripped bonds in a diversified portfolio can provide stability and reduce overall portfolio risk.
• Educational expenses: Parents may invest in stripped bonds to ensure they have the necessary funds for their children’s education when needed.

Stripped bonds are an important financial instrument that separates the interest and principal payments of a bond, creating zero-coupon bonds that provide fixed, predictable payments at maturity. They are useful for matching future liabilities, diversifying investment portfolios, and planning for specific financial needs. However, investors should be aware of the associated risks, including interest rate risk, reinvestment risk, and liquidity risk. Understanding these aspects can help investors make informed decisions about including stripped bonds in their investment strategies.