What is a Strip Bond?

First it should be pointed out how bonds used to work in the old days (they still work this way, but it’s all done electronically).  A bond would actually have coupons attached to them that the bond-holder would clip off and present at a bank in exchange for a payment. Each coupon would have a date that they would come due, and for most bonds a coupon would come due every 6 months.

BondCertificate.jpgIf you had a 10 year bond, then there would be 20 coupons attached to the bond.  A strip bond, ("stripped bond" is a better way to think of it) is when the bank STRIPS off the coupons from the bond and you are left with just the bond "residue" or in other words, the bond without any coupons attached to it.

You wouldn’t pay $100 for a strip bond that matured at $100 10 years from now – that would make for a 0% investment! Instead, you would pay maybe $50 today for a bond that matured in 10 years at $100 and you wouldn’t receive any coupon payments (also known as interest payments) in those 10 years.  BUT the money you invested would be growing at an annual compounding rate of 7.2% in this case (using the Rule of 72).

The other caveat is that your gain (of $50 in this example) would be entirely taxed as interest (and not capital gains) – so in other words it would be fully taxable at your marginal rate.  Normally I would suggest holding this in your RRSP or other tax sheltered account so that you don’t have to make complex calculations to see how much tax you have to pay on an annual basis since interest income is taxable in the year you earn it – not the year you receive it.

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Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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