Posted on: 09-02-11 20:22:00
Can anybody explain in a very simple layman's language, what strip bonds are? Do they provide more return than GIC/Government bonds? Are there any risks involved?
The whole concept of stripping out mortgage interest is just beyond my grasp.
http://www.50plus.com/money/using-strip-bonds-in-your-rrsp/25044/
Does the above help? It is quite layman language. 
Quote:
Originally posted by meghal
Can anybody explain in a very simple layman's language, what strip bonds are?
Regular bonds are made up of coupon payment and the return of face value.
Coupon payment are usually semi-annual.
Upon maturity the face value is returned (hopefully).
Your return is the YTM (yield to maturity).
On the other hand, strip bonds do not have annual/semi-annual coupon payments.
They simply return the face value upon maturity.
Therefore, strip bonds are available for less than face (par) value.
That difference is known as the discount and represents your return and YTM.
Quote:Not necessarily.
Do they provide more return than GIC/Government bonds?
The main benefit of strip bonds is that they remove the re-investment risk, which is one of the primary risks with regular bonds.
When you see a YTM % of a regular bond, it assumes that all coupon payments will be re-invested at the same rate as the coupon on the original bond.
And there-in lies the re-investment risk.
If you do not re-invest the coupon payments immediately or are able to get a higher/lower interest rate on those coupon re-investments, you will not realize the original YTM.
Your return may be lower (or higher).
Strip bonds remove that risk.
You get exactly what you signed up for.
You cannot compare bonds with GIC - there are major differences.
Also, government bonds may or may not be strip bonds.
The issuer is immaterial to the type of bond.
Quote:Of course - the same risks as a regular bond, except for re-investment risk.
Are there any risks involved?
Note that even with strip bonds, you still have the opportunity cost risk i.e. if yields rise during the term of the bond, you have missed out on other opportunity.
Which is why one of the recommended strategies is to build a ladder of bonds using strip bonds.
Laddering is safer and better with strip bonds rather than regular bonds.
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"Mah deah, there is much more money to be made in the destruction of civilization than in building it up."
-- Rhett Butler in "Gone with the Wind"
I'm posting two examples here for you.
These are bond quotes in the secondary market.
The first screen is from a strip bond quote.
The second screen is from a regular bond quote.
The first column is the bond CUSIP Number, the second is the coupon rate, the third is the maturity date, the next is the asking price, the next is the YTM at the ask price.
The last column is the credit rating (DBRS in this case).
http://farm6.static.flickr.com/5137/5436363768_f7bb0ef75c_z.jpg" border="0" alt="http://farm6.static.flickr.com/5137/5436363768_f7bb0ef75c_z.jpg" />
Note that the coupon rate for the strip bonds is 0%.
Also note that the price is less than par (i.e. less than $100 a unit).
This is how the YTM is determined i.e. by buying below par and getting par value back upon maturity.
http://farm5.static.flickr.com/4081/5436363770_d05df81066_z.jpg" border="0" alt="http://farm5.static.flickr.com/4081/5436363770_d05df81066_z.jpg" />
On the other hand, note that in the regular bonds case, there is a coupon rate.
Also, the ask price is more than $100 per unit, inidicating that these bonds are selling at a premium to par.
These days, pretty much all investment grade bonds are selling at premium to par.
The % return in the YTM column takes into account the premium price.
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"Mah deah, there is much more money to be made in the destruction of civilization than in building it up."
-- Rhett Butler in "Gone with the Wind"
