Strip Bonds

When investment dealers acquire a large block of federal or provincial bonds, they sometimes create a product called a strip bond. The coupons for interest payments are literally separated from the portion of the bond representing the principal. The separated coupons and the remaining principal portion are then sold separately to investors.

The buyer of a strip bond pays the market price for the bond, which is determined as its present value at the time of purchase. The present value is a result of the term to maturity (the longer the term, the lower the present value) and current interest rates (higher current rates mean a lower present value). The return for the buyer is the difference between the present value paid and the maturity amount. This return is treated as interest income for tax purposes.† In essence, investors who hold strip bonds until maturity will know their return when the investment is made.

There are a number of benefits to buying a strip bond. Because they are government bonds, they come with a full government guarantee, and they can be sold at any time. Yields are locked in at the time of purchase and together with the bondsí compound growth can produce a substantial payout at maturity. They are particularly effective when held in a registered savings plans.

Strip bonds will not suit an investor seeking regular income from coupons. Also, if they are not held in a registered account, there is a tax liability each year on the accrued interest portion even though the interest is not actually received.

Strip bonds are also known as zero coupon bonds.

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