Using strip bonds in your RRSP

One of the most effective ways to build an RRSP is through the use of strip bonds. The problem is that many people don’t understand what they are, or how they work.

Strip bonds are bonds that have had their interest coupons removed (or stripped). You receive no interest payments over the life of the bond but at maturity it is cashed in for its full face value (normally $1,000). You buy the bond at a discounted price; the difference between the amount you pay for the bond and the face value is your effective return, which you’ll realize at maturity.

The interest coupons that are stripped from the bond are sold in exactly the same way. You buy at a discounted price and hold the coupons until the date the interest due on them is to be paid. You can readily see why brokers love strips — they collect two sales commissions on what was originally just one security.

In the case of both bonds and coupons, the longer the time to maturity, the deeper the discount at which they can be purchased. Sometimes this can be carried to extremes; in early 1995, for example, it was possible to buy a Bell Canada strip bond maturing in 2054 for $5.41 per $1,000 face value. Paick McKeough, best-selling author and editor of The Successful Investor newsletter, calculated that an investment of $5,410 would make you a millionaire in 2054. The problem is that few of us will be around to see it, although, as McKeough pointed out, these bonds might be a way to fund your children’s retirement.

Originally, only Government of Canada and senior provincial bond issues were offered in this form. But as the popularity of strips grew, issues from Crown corporations, senior private companies, and international institutions like the World Bank were made available.

The main attraction of strip bonds for RRSP investors is their long-term guaranteed returns. GICs normally mature in a maximum of five years. Ordinary bonds have longer maturities, but present a reinvestment risk — there’s no way of knowing where interest rates will be when coupon payments come due, so there’s no way of predicting what your bond will be worth.

Strips avoid that problem by guaranteeing a compound annual return at the prevailing rate at the time of purchase. So, if, for example, you buy a 30-year strip yielding 6.5 percent, you know you’ll receive that return each year no matter what.

Well, almost no matter what. When you’re looking that far into the future, there are risks that have to be taken into account. The most fundamental one is: Will the bond issuer be around to pay off the debt when it comes due? We assume that the governments and private institutions that exist today will be around in 20 or 30 years. But will they? What if Quebec separates? What if British Columbia joins the U.S.? What if revolutionary new technology puts Bell Canada out of business? None of this is likely, but it’s not impossible and you must weigh the probabilities in your planning.

Default is a relatively small risk, but market volatility is a much greater one. All bonds experience changes in market valuation, with interest rate movements being one of the most important factors. The longer the term to maturity of the bond, the more volatile it will be. This correlation is so little understood that brokerage firms are required to send an information statement to all strip bond investors advising them of the risks involved.

For example, during the sharp drop in the bond market in spring 1994, some bond mutual funds lost 10 to 12 percent of their value in just a few months. But some strips did much worse. For example, a Nova Scotia Power issue maturing in April 2007, fell 16.6 percent in value between April 1 and June 30. That’s a big loss on a bond in just three months. Strips with longer maturities fared even worse. Fortunately, the Nova Scotia Power strip recovered, although it took almost a year to regain the value knocked off in only three months.

Next page: That’s the critical danger in strips.

That’s the critical danger in strips. Because the market price can fluctuate so dramatically, there’s a risk that an investor will panic and sell, locking in losses that can never be recovered.

That sort of thing happens all too frequently. At the time the bond market was being hammered in 1994, a listener called a phone-in show on CBC radio in Vancouver to say he had recently purchased some strips for his RRSP and now they were down in value. Should he sell? He was assured that he should hold on; that the bond market would eventually rally and his strips would come back. He said he’d follow that advice, and we hope he did. But we know of people who sold their strips when they were down, and took big losses as a result. If you think you might be prone to overreact and sell in a similar situation, then strips are not for you.

The other side of the volatility coin is that strips will rise significantly in value in a falling interest rate environment. For example, on January 3, 1995, you could have purchased B.C. Hydro strips, callable in 2004, with a total maturity value of $13,000 for $5,759.03. That produced a yield to the call date of 9.43 percent. At the end of April, those strips had a market value of $6,188 — a gain of 7.4 percent in just four months. Longer-term strips did even better. A Nova Scotia Power strip maturing in July 2013 gained over 20 percent in value during that four-month period.

Interest rates continued to trend down. In early July 2000, the B.C. Hydro strip had a market value of $10,477.39. Anyone who bought them at the start of 1995 had a paper profit of 66 percent on a conservative investment in just over five years, thanks in part to the fact that they bought just as interest rates were starting to move down.

When this sort of thing happens, the investor faces a pleasant dilemma. Should you sell the strip and lock in the profit, or hold on until maturity?

For conservative investors, we generally recommend holding. You didn’t buy the bond with the idea of trading it, you bought it for the compound interest it would generate for your RRSP. The only exception might be if you have a solid profit and there are very clear signs that interest rates are going to start moving up sharply. In that situation, you may wish to sell part of your holdings with the idea of buying back in when rates are higher and strip bond prices are correspondingly cheaper.

You’ll need a self-directed RRSP to hold strip bonds in your plan. In most cases, this means an annual administration fee of $100 to $150. However, some brokerage firms offer limited no-fee, self-directed plans that allow you to hold strips and other fixed income securities.

Adapted from Gordon Pape’s 2001 Buyer’s Guide to RRSPs, published by Prentice Hall Canada.