A buddy of mine and I were discussing STRIPS this morning and I have a question: I understand how STRIPS work, etc. However, the question is, where does the money come from to pay the par, $1,000, at maturity for each STRIP? Take for example–a 5-year Treasury with a 5% coupon. The total payments over the life of the bond are 1-$1000 and 10-$25 payments, for a total of $1,250. If these are stripped, they will trade at a deep discount, based upon spot rates, however, if 11 of us front money to buy all the STRIPS, where does the $11,000 come from at maturity that is paid back???
Where do you think that $250 extra in your example come from?
You buy a principal or coupon strip. Each coupon payment, like a principal payment is a single bullet payment. Discount it, bingo, there is your price. Whats 1/2 of a coupon worth in X yrs? Whats 1 principal payment worth in X yrs? There you go, pretty simple. In your example, I dont know how you get from 1 single bond (1m in principal) to 11m in notional at maturity. As you said, there are 10 2.5% payments, your $250, and a single 1,000 payment. That is not the same as 11 principal strips, which would be 11 1,000 payments. Big difference.
I am not trying to downplay anyone’s knowledge/response, but I believe grover33 that you are wrong: Check CUSIP: 912833KC3 That is the STRIP INTEREST PMT of 05/15/2014 and it’s trading at a price of 87.66. Every STRIP PRINCIPAL or INT PMT I have seen matures at 100, not the price of the actual coupon payment. Check the 3rd heading, Stripped Coupon Interest: http://online.wsj.com/mdc/public/page/2_3020-tstrips.html
I guess the issue is that if you have to buy a bunch of coupon bonds paying say 5% and then wrap them up into STRIPS, selling the interest payments as zero coupons, then your principal payment is going to be 20x the size of your interest payments. In theory, you could just sell 20x as many zeros at the maturity date, although the supply-demand effects would probably mean you have to take a less attractive interest rate at the maturity date. Another possibility is to buy a bunch of coupon bonds at different maturity dates, so that principal payments are more spread out. You’d be taking on reinvestment risk, but presumably you will be compensated for that by differing interest rate spreads, and the net would be positive on average for the STRIP provider. I assume that provider would get a liquidity premium too, if demand for zeros is higher than the demand for coupons. The mathematics of managing that is more than I could do in my head, but it probably isn’t that challenging with Excel or MATLAB. I should say that all of my FI knowledge is just theoretical; I’ve never seen how it actually works in practice, but that’s my best guess as to how it works.
And just so you know I’m not crazy, I am placing a hypothetical order through my Scottrade account: B 10M of US TREAS STRIPPED INT PMT. Principal value = $8,909.70 with YTM 2.344. That principal value right there should show you I’m not buying the 2.5% or 3% semi-annual coupon payment, because if I was, it would be more like a principal value of: $222.74.
I think where you’re getting lost is the assumption that you can strip one single individual treasury bond - I don’t think you can. My understanding is you have to take a block of them in to the Department of the Treasury, and the smallest size that your block can be is a size that gets you a single coupon strip with $1,000 par. To give you a concrete example, let’s say you owned one standard US 10yr treasury bond with a 5% coupon. You could not take that one single bond with $1,000 par and semiannual coupons of $25 into the treasury and get it turned into one principal strip with par $1,000 and 20 coupon strips with par $1,000 - as you point out, they would be giving you free money. You would have to collect 40 of these bonds, then take them in to the US Treasury, and they would turn them into 40 principal strips with par $1,000 and 20 coupon strips of $1,000 par each. In reality, stripping is done by big dealers who are handling tens of millions of dollars worth of treasuries, so it’s not that hard for them to come up with a strippable quantity. I have never heard of an individual investor trying to strip bonds on their own.
I think where you’re getting lost is the assumption that you can strip one single individual treasury bond - I don’t think you can. My understanding is you have to take a block of them in to the Department of the Treasury, and the smallest size that your block can be is a size that gets you a single coupon strip with $1,000 par. To give you a concrete example, let’s say you owned one standard US 10yr treasury bond with a 5% coupon. You could not take that one single bond with $1,000 par and semiannual coupons of $25 into the treasury and get it turned into one principal strip with par $1,000 and 20 coupon strips with par $1,000 - as you point out, they would be giving you free money. You would have to collect 40 of these bonds, then take them in to the US Treasury, and they would turn them into 40 principal strips with par $1,000 and 20 coupon strips of $1,000 par each. In reality, stripping is done by big dealers who are handling tens of millions of dollars worth of treasuries, so it’s not that hard for them to come up with a strippable quantity. I have never heard of an individual investor trying to strip bonds on their own.
I think where you’re getting lost is the assumption that you can strip one single individual treasury bond - I don’t think you can. My understanding is you have to take a block of them in to the Department of the Treasury, and the smallest size that your block can be is a size that gets you a single coupon strip with $1,000 par. To give you a concrete example, let’s say you owned one standard US 10yr treasury bond with a 5% coupon. You could not take that one single bond with $1,000 par and semiannual coupons of $25 into the treasury and get it turned into one principal strip with par $1,000 and 20 coupon strips with par $1,000 - as you point out, they would be giving you free money. You would have to collect 40 of these bonds, then take them in to the US Treasury, and they would turn them into 40 principal strips with par $1,000 and 20 coupon strips of $1,000 par each. In reality, stripping is done by big dealers who are handling tens of millions of dollars worth of treasuries, so it’s not that hard for them to come up with a strippable quantity. I have never heard of an individual investor trying to strip bonds on their own.
Sorry, posting trouble - I’ll delete the two extras if someone can tell me how…
Redneck is right on. In reality you trade them in the same types of sizes as a standard bond - 100 is par. You are buying a bunch of coupon payments or principal payments all packaged together to form your notional value. You arent going to go out and pay 87 for a 25 dollar interest payment, you are going to pay 87 (percent of par) on a minimum of, say, 1,000 in notional, so a bunch of interest payments put together. It is a way to make them pseudo-fungible (i know, bad use of the term) with one another - zero’s, p-strip, c-strip, etc. Nothing fancy.
soxboys21 Wrote: ------------------------------------------------------- > I am not trying to downplay anyone’s > knowledge/response, but I believe grover33 that > you are wrong: > > Check CUSIP: 912833KC3 > > That is the STRIP INTEREST PMT of 05/15/2014 and > it’s trading at a price of 87.66. > > Every STRIP PRINCIPAL or INT PMT I have seen > matures at 100, not the price of the actual coupon > payment. > > Check the 3rd heading, Stripped Coupon Interest: > > http://online.wsj.com/mdc/public/page/2_3020-tstri > ps.html Something else that seems worth pointing out, and has been touched on by the posts above, is that the numbers on that page are percentages of par, not actualy $ values. So even in the case that you could have a stripped coupon from a single bond of $25, you wold be paying 87% of it (~$22) and it would mature at 100% ($25)