Have you ever heard of a strip bond? It’s an investment that is not as well-known as stocks or mutual funds but could be a valuable addition to your portfolio. Strip bonds are a unique fixed-income investment type becoming increasingly popular among investors.
If you’re interested in diversifying your investment portfolio and want to learn more about strip bonds, you’ve come to the right place.
In this article, we’ll discuss what strip bonds are, how they work, and the potential benefits and risks of investing in them. By the end of this article, you’ll better understand strip bonds and whether they are right for you.
How Does a Strip Bond Work?
Strip bonds, also known as zero-coupon bonds, are created by stripping the interest payments from a traditional bond and selling them separately as individual securities. The principal component of the bond is also sold separately as its own security.
For example, let’s say there is a $1,000 bond with a 10% coupon rate and a maturity of 10 years. The interest payments on this bond would be $100 per year for ten years. However, if the bond were stripped, the $1,000 principal and the $100 interest payments would be sold separately as two distinct securities.
Investors who purchase the principal component of the bond, also known as the “strip,” pay a discounted price for the security, typically at a rate that is lower than the face value of the bond. The market determines the discounted price and depends on various factors, including prevailing interest rates, the issuer’s creditworthiness, and the time remaining until the bond matures.
The interest component of the bond, or the “stripped coupon,” is also sold separately and can be purchased by investors looking for a fixed return without the need for periodic interest payments. The stripped coupon is sold at a price that is also determined by the market and reflects the future interest payments of the original bond.
At maturity, the investor who purchased the strip receives the full face value of the bond, while the investor who purchased the stripped coupon receives the full value of the periodic interest payments. Overall, strip bonds provide investors with an alternative way to invest in fixed-income securities while potentially offering advantages such as a fixed return, tax advantages, and diversification.
Advantages of Zero-Coupon Bonds
Strip bonds, also known as zero-coupon bonds, offer several advantages, including:
- Fixed return: Strip bonds offer a fixed rate of return, which can be attractive to investors looking for a predictable return on their investment.
- Discounted price: Strip bonds are sold at a discount to their face value, which means investors can purchase them for less than their eventual payoff value. This can make them an attractive option for investors looking to lock in a future return at a discounted price.
- Tax advantages: Because strip bonds do not pay interest, investors do not have to pay taxes on the interest income until the bonds mature or are sold. This can be advantageous for investors in high tax brackets.
- Diversification: Strip bonds can diversify an investment portfolio, offering a different risk and return profile than traditional bonds or stocks.
- Low volatility: Because strip bonds have no periodic interest payments and are sold at a discount to their face value, they tend to have lower volatility than other fixed-income investments.
Strip Bond Taxation in Canada
In Canada, the taxation of strip bonds depends on whether they are held in a registered or non-registered account.
If the strip bonds are held in a non-registered account, the investor is taxed on the imputed interest that accrues each year, even though there is no actual interest payment. The imputed interest is calculated as the difference between the bond’s purchase price and its face value at maturity. This imputed interest is taxable income subject to federal and provincial taxes.
If the strip bonds are held in a registered account, such as a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA), there is no tax on the imputed interest as long as the funds remain in the registered account. However, when the investor withdraws funds from an RRSP, the withdrawal amount is considered taxable income, but with a TFSA, all gains are tax-exempt.
Other Investments Comparable to Strip Bonds in Canada
Several other types of investments are comparable to strip bonds in terms of their risk and return characteristics, including:
Government of Canada Real Return Bonds (RRBs)
RRBs are also issued by the Canadian government and offer a fixed rate of return adjusted for inflation. RRBs are sold at a premium or discount to their face value and offer investors protection against inflation.
Guaranteed Investment Certificates (GICs)
GICs are a type of time deposit offered by Canadian banks and credit unions that provide a fixed rate of return over a specific period of time. Like strip bonds, GICs do not offer periodic interest payments and are sold at a discount to their face value. Read more about GICs vs different kinds of bonds.
Provincial and Municipal Bonds
Like in the United States, Canadian provinces and municipalities issue provincial and municipal bonds and offer a fixed rate of return. In addition, these bonds may provide tax advantages for Canadian investors, as the interest income may be exempt from federal and provincial taxes.
Canadian corporations issue corporate bonds and offer a fixed rate of return over a specific period of time. Like strip bonds, corporate bonds do not provide periodic interest payments and may be sold at a discount to their face value.
What are Retractable Bonds?
Retractable bonds are a type of bond that gives the holder the option to redeem the bond before maturity at a predetermined price. They are also known as puttable bonds or redeemable bonds.
Retractable bonds typically have a set maturity date, but they also offer investors the option to redeem the bond early, usually after a set period of time. In addition, the price at which the bond can be redeemed is predetermined and is typically par value or a premium above par value. This feature makes retractable bonds more flexible than traditional bonds because it allows investors to cash out early if they need to while still providing a fixed income stream.
The ability to redeem the bond early is attractive to investors because it provides protection against interest rate fluctuations.