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How do strip bonds work? What's the best way to use them?

Strip bonds are a special type of bond because they don't pay interest. Instead, you buy them at a discount, and they mature at their face or principal value.

Regular bonds, on the other hand, give you regular interest or coupon payments, usually twice a year, with your principal repaid on the bond's maturity date. Strip bonds are created by investment dealers, usually out of high-quality federal or provincial government bonds. Some or all of the interest coupons are separated or stripped from the bond certificate. The "coupons", promises to pay set interest amounts on a future date, are sold separately from the so-called bond residue. The "residue" is a promise to pay the face value when due, plus any interest coupons that weren't stripped.

The coupons and the residue are sold at a discount to their face value because money in the future is worth less than money today. Both coupons and residues are known as strip bonds or as zero coupon bonds. If you bought the residue of a 20-year bond with a face value of $10,000, it would cost you about $3,066 if its yield to maturity is 6%. You would pay $3,066 for today, and, if you held it to maturity 20 years, you'd be paid $10,000. Your return on this 20-year strip bond would be about $6,934 -- the difference between what you paid and what you eventually get at maturity. This works out to an annual compounded return or yield of 6%. That 20-year bond, before it was stripped, would have had 40 coupons - one due every six months. So if you bought the particular coupon that comes due in 10 years, you'd have a 10-year strip bond. A strip bond's market price will vary as interest rates rise and fall. A rise in interest rates generally causes all bond prices to fall; a drop in interest rates causes bond prices to rise. The price swing will be more dramatic since none of your return is paid until maturity. As the strip's maturity nears, its price moves closer and closer to the face value, which is what you receive at maturity. Like other bonds, there is potential to sell strips for a capital gain if interest rates fall after you buy. In this case, some of your earnings would be taxed as capital gains and some at your full tax rate as interest income. Most investors who have strip bonds favor those with the best credit rating; such as government bonds, to ensure that they in fact will receive their full face value at maturity.

Advantages of strip bonds

By making a relatively small investment today, you will end up with a larger, known sum years down the road at maturity, earning what could be an attractive interest rate. Strip bonds eliminate reinvestment risk during your holding period. Since your bond doesn't pay interest every six months, you don't have to keep worrying that interest rates will be down when you receive -- and may want to reinvest -- those interest payments.

Disadvantages of strip bonds

They may be hard to sell before maturity because there isn't an active secondary market for them. This means that if you have to sell before maturity, you may receive a low price since there may not be many of buyers; Because they don't pay interest, a rise in interest rates will cause them to fall further and faster than regular bonds. This could be a problem if you want to sell before maturity. Of course, their prices will also jump to greater heights, and more quickly if interest rates fall. Even though you don't actually get any income from your strip bond each year, Revenue Canada considers that you do. This means you have to pay tax on that deemed income each year -- even though you haven't actually received any income. Because these earnings are treated as interest, not capital gains, you pay tax at your full regular rate. The difference between what you paid for the strip and what you receive at maturity is considered to be interest. You have to declare a proper proportion of that each year on your taxes.

Consider strip bonds for your RRSP

The tax angle makes strip bonds a poor choice outside of a tax shelter. But if you hold them in your self-directed RRSP, you don't pay any tax on your return until you take your investment out of your RRSP. Aside from the tax aspect, strip bonds are also well suited for your RRSP because they lock in a set, known interest rate for terms of up to 30 years. Your earnings are automatically reinvested. One RRSP strategy is to pick a strip bond maturity to match your retirement needs. If you will retire in 20 years, you might buy a 20-year strip bond. Consider seeking professional investment advice. Investments and strategies that suit some investors will not necessarily meet your needs.