Chapter 6 Stripped bonds.
Stripped bonds are artificially "manufactured" zero-coupon bonds (see Chapter 7). These zero-coupon bonds are "manufactured" when investment bankers buy blocks of coupon-paying bonds (typically long-term government Treasuries) and separate them into two components: (1) the coupons (which have been "stripped" from the bond); and (2) the principal (the "stripped" bond). Each component is sold separately. The principal is sold at enough of a discount to provide a competitive market yield to maturity.
WHEN IS THE USE OF THIS TOOL INDICATED?
1. When investors want to be assured of reinvestment at the yield to maturity (unless the bond is called or sold before maturity).
2. Because of the certainty of the reinvestment rate, investors can better predict and plan for specific accumulated values at the maturity date.
3. Taxable strips are very suitable conservative investments for retirement plans.
4. Tax-exempt strips are an excellent vehicle for children under age 18 who are subject to their parents' tax rate on unearned income.
5. Strips are suitable when a known lump sum is needed at a specific future time.
ADVANTAGES AND DISADVANTAGES
1. Prices of stripped bonds are more sensitive to interest rate changes than prices of coupon-paying bonds of the same quality and maturity. Specifically, the market price of stripped bonds will fall (rise) when market interest rates increase (decrease) much more than the market price of comparable coupon-paying bonds. In addition, the size of the move in the market price associated with a given change in market interest rates will be greater the longer is the term until maturity of the bond. Consequently, in periods of historically low interest rates, such as in the early years of the 2000-2010 decade, investors bear considerable risk of sustaining large capital losses in the event market interest rates rise and they are forced to sell the stripped bonds before they mature.
2. Many stripped bonds are callable at the discretion of the issuer. If a strip is called before maturity--which is more likely to occur when interest rates have fallen--the investor will generally not be able to reinvest the proceeds at the yield to maturity he enjoyed on the stripped bond. However, some strips are issued with call protection to assure investors that the bond will not be called for a specified period or not at all. Corporate and municipal strips are more likely to be callable than United States Treasury-based strips.
1. Unless the bond is a tax-exempt municipal issue, interest is subject to tax as it accrues even though no cash is paid until the bond matures or is called. However, in the case of a tax-exempt bond stripped after June 10, 1987, a portion of the original issue discount may be treated as if it comes from a taxable obligation.
2. The original issue discount (OID) rules generally determine the amount of interest that accrues each period for tax purposes. In a nutshell, for bonds issued after April 4, 1994, OID must be accrued at a constant rate, effectively equal to the yield to maturity. The accrued interest each period is added to the investor's basis in the bond. Gain or loss, if any, upon disposition of the bond prior to maturity is equal to the difference between the sale price and the original issue price plus the accrued interest to the date of sale. The rules for computing the taxable interest for stripped bonds issued before April 4, 1994 differ somewhat, depending on when they were issued. (1)
3. If the underlying securities are federal government issues, there is some question as to whether the interest is exempt from state taxation. If the interest is United States government interest, the interest is exempt from state tax. If the interest is from the investment banker who "manufactures" the strip, the interest would be subject to state taxation.
1. Stripped federal government securities have many different names, depending on the investment banker that "manufactures" the stripped bond, including:
(a) CATs--Certificates of Accrual on Treasury Certificates
(b) COUGRs--Certificates of Government Receipts
(c) STAGs--Sterling Transferable Accruing Government Securities
(d) STRIPs--Separate Trading of Registered Interest and Principal of Securities
(e) TIGRs--Treasury Investment Growth Certificates
(f) ZEBRAs--Zero-Coupon Eurosterling Bearer or Registered Accruing Certificates
2. Stripped tax-free municipal bonds have one very important advantage over original issue zero-coupon municipals (which have been available for years): most of the tax-free strips are not callable while virtually all of the zero-coupon municipals are callable. Consequently, investors who buy tax-free strips have much more certainty about the holding period and their reinvestment yield.
Furthermore, some of the new tax-free strips are guaranteed by "pre-refunding." In other words, they are backed by United States Treasury bonds that have been purchased to guarantee payment if the municipality goes bankrupt, or is slow in paying investors when the bonds matures.
3. Another way to purchase zero-coupon instruments is through a target-maturity mutual fund. These open-end, no-load mutual funds--which typically require $2,500 as a minimum investment--specify a particular termination date. These funds invest in STRIPS and coupon-paying Treasury bonds that match the specified termination date, pay little or no interest during the life of the fund, and pay out a lump sum at the fund's termination date.
Some care should be exercised in the selection of target-maturity mutual funds. Some of the funds listed as target-maturity mutual funds (for instance, some of those offered by Kemper) are actually hybrid funds that combine STRIPs maturing at specified dates with investments in equities or other assets. The objective of these funds is to assure that investors will receive at least a "minimum" value at a specified future date together with the earnings and appreciation, if any, on the other assets. Although these hybrid funds may have a place in satisfying investors' objectives, they will not have the same risk, return, and tax features as pure target-maturity mutual funds.
(1.) See IRC Secs. 1271 through 1273, and the related regulations for a discussion of the rules as they apply to stripped bonds issued before April 4, 1994 and for certain other special rules as they apply to stripped bonds.