Strip bonds are fixed-income instruments created by separating a bond's coupon payments from its principal repayment. Each component then trades individually as a zero-coupon security, purchased at a discount and repaid at face value when it matures. Strip bonds provide a mechanism for investors considering fixed-income choices to lock in a known future value without worrying about reinvestment.
What are Strip Bonds?
Strip bonds are zero-coupon securities that have their principle and interest installments offered separately.
Periodic interest is not paid on a zero-coupon bond. Instead, when it matures, it is redeemed at face value after being purchased at a discount. The return comes from the difference between the purchase price and the maturity value.
For example, a 10-year government bond with semi-annual coupons can be split into twenty coupon strips and one main strip. Every component turns into a separate security with its own market price and maturity date.
How Does Bond Stripping Work?
Bond stripping separates a coupon-bearing bond into individual cash flow components that may be traded independently.
In India, this facility applies to selected government securities identified by the RBI.
Step-by-Step: From Coupon Bond to Stripped Security
The process generally follows these steps:
Step 1: RBI identifies eligible government security.
Step 2: A holder submits a stripping request.
Step 3: Coupon payments and principal repayment are separated.
Step 4: Individual strips are credited as separate securities.
Step 5: Each strip may be traded independently.
Step 6: Strips may later be recombined into the original bond through reconstitution.
Principal Strip vs. Coupon Strip (Types)
Strip bonds are available in two forms: coupon strips and principal strips. Each type represents a different future payment from the original bond.
| Attribute | Coupon Strip | Principal Strip |
|---|---|---|
| What it represents | Single interest payment | Final principal repayment |
| Face value | Equal to coupon amount | Equal to original face value |
| Maturity date | Original coupon payment date | Original redemption date |
| Duration | Shorter | Longest among all strips |
| Price sensitivity | Lower | Higher |
| Typical buyer | Investors matching shorter liabilities | Pension funds and insurers |
How to Calculate Returns / YTM
Strip bonds do not pay regular interest during the investment period. Investors earn returns from the difference between the purchase price and maturity value.
Yield to Maturity (YTM) shows the annual return earned when held until maturity.
The YTM Formula for Zero-Coupon Securities
YTM = (Face Value ÷ Purchase Price)^(1/n) − 1
Where:
Face Value = Amount received at maturity
Purchase Price = Amount invested
n = Years remaining until maturity
A lower purchase price generally results in a higher yield for investors.
Example
Consider a principal strip with the following details:
Face Value: ₹1,00,000
Purchase Price: ₹50,000
Maturity Period: 10 years
The investor pays ₹50,000 today and receives ₹1,00,000 at maturity. No interest payments are received during the holding period.
| Purchase Price (₹) | Duration (Years) | Implied YTM (%) |
|---|---|---|
| 75,000 | 5 | 5.92% |
| 50,000 | 10 | 7.18% |
| 60,000 | 8 | 6.59% |
| 40,000 | 12 | 7.87% |
| 30,000 | 15 | 8.36% |
So, the Implied YTM: is 7.18% per annum
Advantages of Strip Bonds
Strip bonds offer several features that may benefit investors with long-term financial goals.
- No Reinvestment Risk: Investors do not need to reinvest interest because no coupon payments are received.
- Known Maturity Value: The amount received at maturity is known when the investment is made.
- Useful for Future Goals: Investors can match bond maturity dates with planned financial requirements.
- Simple Structure: Returns depend on one future payment, making valuation easier to understand.
- Government Backing: Government security strips carry the credit quality of the Government of India.
Risks of Strip Bonds
Investors should consider the risks associated with strip bonds before making an investment. Investors may be better able to make wise investing choices if they are aware of these hazards.
- Interest Rate Risk: If market interest rates increase throughout the holding period, prices may drop precipitously.
- Liquidity Risk: In the secondary market, it might occasionally be challenging to find purchasers before maturity.
- No Regular Income: Throughout the investment period, investors do not receive recurring cash flows.
- Inflation Risk: Over time, inflation may lower the real value of proceeds from future maturities.
- Tax Complexity: Compared to certain conventional fixed-income assets, tax treatment may be more complicated.
Tax Treatment in India
The holding period and relevant rules determine how strip bonds are treated tax-wise. Bonds sold within a year are typically seen as short-term capital gains. Typically, the investor's applicable income tax bracket determines how these gains are taxed.
Gains on strip bonds that are held for longer than a year are often regarded as long-term capital gains. Subject to present legislation, long-term profits may be taxed at 12.5% without indexation.
TDS may also apply when bond income exceeds prescribed limits. The applicable TDS rate is generally 10% when PAN is provided. The rate may increase to 20% if PAN details are not available.
How to Invest in Strip Bonds
Strip bonds are available for purchase by investors via authorised government securities platforms and intermediaries.
Step 1: Create an account with an authorised broker or RBI Retail Direct.
Step 2: Look for accessible strip bonds and examine the characteristics of their maturity.
Step 3: Before choosing an appropriate bond, evaluate prices, yields, and liquidity.
Step 4: Use the selected investing platform to place the buy order.
The bond can be sold on the secondary market or held until it matures.
Strip Bonds vs. Zero Coupon Bonds
Zero-coupon bonds and strip bonds are similar in that they both don't pay periodic interest.
| Parameter | Strip Bonds | Zero Coupon Bonds |
|---|---|---|
| Origin | Created from existing coupon-bearing bonds | Usually issued directly as zero-coupon instruments |
| Interest Payments | None | None |
| Purchase Method | Created through bond stripping | Issued directly by the issuer |
| Return Source | Difference between purchase price and maturity value | Difference between purchase price and maturity value |
| Maturity Structure | Multiple maturity dates | Single maturity date |
Conclusion
The principal and coupon payments of a bond are divided into distinct zero-coupon securities to create strip bonds, which are fixed-income instruments. They are suitable for long-term financial goals, have no risk of reinvestment, and have predictable future value. Investors should consider inflation risk, taxation, interest rate sensitivity, and liquidity limitations before making an investment. The suitability of strip bonds depends on an individual's financial objectives, risk tolerance, and investing horizon.
Frequently Asked Questions About Strip Bonds
What is the difference between strip bonds and zero-coupon bonds?
An existing coupon-bearing bond is divided into separate cash flows to generate strip bonds, a kind of zero-coupon bond. Some zero-coupon bonds are issued directly as zero-coupon securities; not all of them are strip bonds.
Are strip bonds available in India?
Yes. For qualified Government of India assets, the RBI implemented the Separate Trading of Registered Interest and Principal Securities (STRIPS) facility in 2010 to enable trading of strip bonds. These securities are accessible to investors via market intermediaries and authorised platforms.
What is the minimum investment amount for strip bonds?
Although real investment requirements vary depending on the platform, market lot size, and trading conditions, government securities typically have a face value of ₹100.
How are strip bonds different from regular coupon bonds?
Regular bonds restore principal at maturity and pay interest on a regular basis. Strip bonds deliver the maturity value as a single payment at the end of the term and offer no interim payments.
Are strip bonds associated with zero risk?
No. While government-backed strips carry low credit risk, they remain exposed to interest rate risk, liquidity risk, and inflation risk.
What happens when a strip bond matures?
At maturity, the investor receives the face value of the strip bond. The amount is credited through the applicable settlement system.
Can NRIs invest in strip bonds in India?
Subject to RBI norms and FEMA laws, NRIs may invest in government securities. The investment path and current laws determine eligibility.
How are strip bonds taxed compared to fixed deposits?
Interest on fixed deposits is subject to taxation based on the investor's income tax bracket. Depending on the holding duration and relevant rules, strip bonds are typically subject to capital gains taxation. TDS may apply in certain situations.
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