Zero coupon or strip bonds are fixed income securities that are created from the cash flows that make up a normal bond.
The cash flows of a normal bond consist of the regular interest or "coupon" payments, that take place over the term of the bond, and the principal repayment that occurs at maturity of the bond. For example, the cash flows of the Government of Canada 8% bond with a maturity date of June 1, 2023 are:
- $4 every December and June 1st up to and including June 1, 2023, representing 4% of the $100 par value; and
- $100 on June 1, 2023, representing the repayment of the principal or par amount of the bond.
Taken individually, each of these payments is an obligation of the issuer, in this case, the Government of Canada. The process of "stripping" a bond involves deppositing bonds with a trustee and having the trustee separate the bond into its individual payment components. This allows the components to be registered and traded as individual securities. The interest payments are known as "coupons" after their source of cash flow, and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are known as "zero coupon" bonds or "zeros".
Initially, when this process first took place in the early 1980s, the individual coupons were "physical", which meant that an actual paper certificate existed for each coupon and the residual. Now these securities are "book based" which means that they are entries on a centralized financial registry system known as the Central Depository System (CDS).
Once a bond has been stripped, a trustee directs the appropriate amount of the interest or maturity payment to the security holders. The holder of a zero coupon receives the par amount of the particular term of the zero that she holds. For example, an investor holding $100,000 par amount of the December 1, 2001 coupon would receive $100,000 on that date.
Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The investor pays something up front in exchange for a promise to receive $100 on the maturity date. Take our example of the coupons and residual generated by stripping the Canada 8% of 2023. If we start on December 1, 1996 the first two payments are identical to a 6 month and 1 year T-Bill. An investor would receive $100 on June 1st and December 1st for each $100 par amount she purchased of these terms of coupons.
The basic mathematics are easy. What should an investor pay for the 1 year coupon? If the investor demands a 4% return over a one year period, she should pay something around $96 for the $100 maturity value (actually $96.154 since we're starting at less than $100).
The longer coupons get a bit more complicated. Take the coupon due on December 1, 2001, five years from December 1, 1996. What do we pay for this $100? First of all, we need to consider what interest rate would be appropriate. Reflecting on the term structure of interest rates, we know that we should use the yield on a similar term Government of Canada bond. Being bond market fans, we just happen to know that there is a Government of Canada issue the 9.75% of December 1, 2001. We also know that it currently yields 5.6% semiannually.
As a rough cut, forgetting the compounding of interest (interest-on-interest) and the conversion to semiannual yields, we know that 5.6% for 5 years is 28%. This means if we pay something around $72 (100-28) on December 1, 1996 for the $100 coupon due on December 1, 2001, we will earn something around 30% over the period or 6% a year.
Pulling out our trusty bond calculator, we can actually do the calculation. At a semiannual yield of 5.6%, the price works out to be $75.91. At a semiannual yield of 6%, the price works out to be $74.44.
Of course, nothing is as easy as it seems. The yield of a zero coupon bond is different than the yield of a normal bond of the same issuer. This difference of "spread" reflects the economics or profits available to investment dealers from "stripping" activities and the supply and demand for zero coupon bonds. There is also a difference in yield between coupons and residuals which reflects the larger size of residuals and the economies of trading compared to many smaller coupon positions or "lines".
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