Nonstandard Bonds

We discuss hereafter strips, floating-rate notes and inflation-indexed bonds. Convertible bonds and bonds with embedded options are discussed in depth in Chapter 14. Strips Strips (Separate Trading of Registered Interest and Principal) are zero-coupon bonds mainly created by stripping government bonds of the G7 countries.2 The strips program was created in 1985 by the US Treasury Department in response to investment banks who, in the early 1980s, had been buying long-term Treasury bonds and then issuing their own zero-coupon bonds, collateralized by the payments on the underlying Treasury bonds. These so-called trademark zeros were a success, but because of the higher liquidity of strips, they were dominated by them.

The only cash flow distributed by strips is the principal on the maturity date. Such a bond that yields no coupon interest over the investment period may seem rather peculiar and unattractive. In fact, it typically bears interest on the maturity date as it is bought at a price that is lower than its maturity price. The investors who buy these bonds are usually long-term investors like pension funds and insurance companies, and have at least one main purpose, which is securing a return over their long-term investment horizon. To understand this point, consider an investor who is supposed to guarantee 6% per annum over 20 years on its liabilities. If he buys and holds a strip with a maturity equal to its investment horizon, that is 20 years, and a YTM of 6%, he perfectly meets his objective because he knows today the return per annum on that bond, which is 6%. In contrast, coupon-bearing bonds do not allow him to do so, because first they bear an interest reinvestment risk and second their duration hardly ever, if not never, reaches 20 years (see Chapter 5 on this point).

There exist two types of strips—coupon strips and principal strips. Coupon strips and principal strips are built by stripping the coupons and the principal of a coupon-bearing bond, espectively. The main candidates for stripping are government bonds (Treasury bonds and government agency bonds). Strips are not as liquid as coupon-bearing bonds. Their bid–ask spread is usually higher.

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