Bonds in which the coupons have been detached from the bond itself, leaving only the maturity (principal or residual) amount at the maturity date are called “Strip”, “Zero-Coupon” or Residual Bonds. We will call the strip coupons also strip bonds and refer to the due date of the coupon as also the maturity date. The striped bond maturity amount and the coupons trade separately.

The interest on your purchase price accumulates year by year and your purchase price plus accumulated interest is paid in total at the maturity date of the bonds. These bonds are also referred to as compound interest bonds. In between the purchase date and maturity date the strip bonds may trade in the market at discounts or premiums.  Of course, if you hold the strip bond to the maturity date then what happens in between these two dates does not affect your rate of return which can be calculated when you purchase the bond. Hence in the case when you purchase government, government backed or equivalent, Strip bonds are extremely secure and stable.

However, should you need to sell your strip bond before maturity you may find that the market price may deviate substantially from your purchase price plus accumulated interest calculated. This is because as interest rates rise people expect a higher return on their investment. This can only be accomplished by the market value of bonds dropping and hence resulting in higher returns. Conversely when interest rates drop, the market price of bonds usually rises because buyers are satisfied with a lower return than previously. Thus strip bonds can be very volatile especially when interest rates are changing.

The interest earned on a strip bond, according to Revenue Canada must be reported year by year as ordinary interest income. Below is an example of a Strip Bond whose quotation was found on TDWaterhouse. The bond is issued by the Province of Ontario and we are told that you can purchase $100 face value or principal amount of this bond for $75.787 and receive the maturity value of $100 on January 13 2024. We will assume the bond is actually paid for on October 1 2014. The quotation also tells us that we will earn a rate of 3.01623% per annum compounded half yearly if bought for $75.787.

We set up the above table which tells us that that $75.787 invested on Oct. 1 2014 for 9.28493 years will give us $100 on Jan. 13 2024 (and nothing else).

If we weren’t given the rate of return we could find it as follows:

The yearly effective interest rate per year earned on this investment. Using the compound interest formula (you may ignore this), we obtain 75.787*(1+i)^^9.284932 =100. Then i =(100/75.787)^^(1/9.28493)-1 =.0303 or 3.03%

Let k be the equivalent rate per annum compounded half yearly. Using excel (which you can ignore) we solve for k.

1.0303=(1+k/2)^2, k= 2*(SQRT(1.0303)-1 = .0301 or 3.01% per annum compounded half yearly. Any difference between the quoted rate and our rate is due to the uncertainty on the settlement date, rounding and a slightly different method used.

We shall use the rate 3.03% effective yearly to form the table below showing how the $75.787 grows to $100 by compounding year by year

As was said before, if you wanted to sell the bond before maturity date the price can vary a great deal . For example, If you wanted to sell your bond on January 13 2019 and interest rates were at 6% per annum you would receive approximately $74.73. If rates were at 2% per annum you would receive approximately $90.57.

Guaranteed Investments —-You Cannot Lose!

You have all seen ads to the effect that for certain structured investments your principal amount will be guaranteed to be paid at the end of a fixed period regardless of how the markets perform but your profits are unlimited. That is, you might end up not making any money but have the comfort of knowing that you cannot lose any money. Sounds too good to be true? Well, suppose we construct such a situation. We will use Strip Bonds as described below.

Using the previous example you can set up such an investment on your own. You are going to invest, say $100, on Oct. 1 2014 and you will terminate your investment on January 1 2024. Invest $75.79 in the strip bond described above. This guarantees that your initial investment of $100 is returned to you on Jan. 1 2024. Also use the remainder of your $100 investment i.e., 100 – 75.79 = $24.21 to invest in stocks or any other securities. Even if this investment of $24.21 is a complete flop and it dwindles to $0, on Jan. 1 2024 your $100 will be returned to you via the Strip bond.

On the other hand, if your investment of $24.21 resulted in an accumulated doubling to $48.42 on Jan. 1 2024, you will have earned a return of 4.345% per annum compounded yearly.

This kind of structured investment is best done in a registered plan such as an RRSP or RESP since there will be no tax consequences until the plan matures. If done outside a registered plan you would probably have to pay tax every year on the interest earned by the strip bond.