# Strip bonds

Tried and true investments, strip bonds offer a safe haven. Here’s how to calculate your rate of return.

Strip bonds are created by separating a bond into its two components – a series of interest payments known as coupons and due at regular intervals and a final repayment of the bondholder’s principal or face value at maturity, known as the residual. The coupons and the residual are both referred to as strips and are sold as separate securities.

Also known as zero-coupon bonds, strips are typically created from high-quality federal or provincial government bonds. In an RRSP, a long-term strip bond offers investors a safe and competitive rate of return. Strip bonds come with various terms to maturity, some with ranges as long as 30 years.

Benefits of strip bonds
Part of the attraction of strip bonds for both brokers and investors is the ease with which rates of return can be calculated. A coupon or residual is purchased at a discount to its maturity or face value. The difference between what you pay and the bond’s face or maturity value represents your return.

For example, a strip bond residual with a marity date 20 years from now might be purchased now for \$27.797 for each \$100 of face value. (Like the price on other types of bonds, strip-bond prices are quoted in denominations of \$100.) So, at this time, a strip-bond investment with a maturity or face value of \$5,000 (50 x \$100) would cost \$1,389.85 (50 x \$27.797). At maturity, in 20 years, your return would be \$3,610.15 (\$5,000 – \$ 1,389.85).

The return on a coupon is calculated in a similar way. Keep in mind that the coupons represent the scheduled semi-annual interest payments on a bond. Keeping with the bond used in the example above, say you purchased a coupon that was payable on the bond’s maturity date. You would now be entitled to one of the bond’s original semi-annual interest payments. If the bond paid interest of 9 per cent annually, the final interest payment on the \$5,000 principal would be \$225, calculated as \$5,000 x 0.09 and divided by 2. (Remember that interest is paid twice a year and your coupon represents one of these semi-annual payments). So, you would pay \$62.54 (\$225 x \$0.27797) and your total return at maturity would be \$162.46 (\$225 -\$62.54).

By contrast, determining your return on a regular bond – one that makes regular interest payments and repays the principal or face value at maturity – is more complex. For one thing, your return would depend on pending interest payments as well as the market price of the bond. Since bond prices fluctuate with market conditions, rarely does a bond trade at its face value, and this makes it difficult to determine the value of your investment.

Strips, especially coupons, also offer an advantage to smaller investors in that they require relatively small initial investments and may be more accessible than other fixed-income securities. The fact that some strip residuals have very long terms also makes them good RRSP investments –provided your time horizon is suitable.

Negative consequences

However, strip-bond investors should also be aware these securities have some potentially negative tax consequences. The main one is that, although you don’t actually receive any payments or realize any gains from a strip bond until maturity, you’re still required to report an annualized portion of the accrued interest to Canada Customs and Revenue Agency (CCRA) (formerly Revenue Canada) for income tax purposes. In the above example of our strip coupon, you would have earned \$162.46 over 20 years. Although you would be paid this interest at the maturity date, you must report this return to CCRA on an annualized basis and would be liable for \$8.12 (\$162.46 divided by 20) in annual interest income in each of the 20 years.

The fact that income from strip bonds is in the form of interest and subject to the highest rates of tax makes it even more important to consider carefully where you hold these financial instruments. Outside a tax-deferred account such as an RRSP, an RRIF or other registered plan, strip bonds are generally unsuitable.

Although buying and holding may be the best strategy for most strip-bond investors, strips are highly liquid and can be bought and sold in the market at any time. Like the price on regular bonds, the market price of a strip bond moves with interest rates. So, you have the opportunity to sell a strip bond for a gain when bond prices are rising — as they would if interest rates are falling — and you’ll find that your bond’s value on the market falls in an environment of rising interest rates.