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What are strip bonds?

Bearer bonds feature detachable coupons – also referred to as strip bonds, or zero-coupon bonds. In comparison to regular bonds, which usually pay interest semi-annually, these bonds do not pay interest but are sold at a discount value to the face value. While holders of strip bonds do not receive interest payments, purchasing the bonds at a discount results in a certain compounded rate of return, or profit, at maturity.

Strip bonds first appeared in Canada in 1982. They are usually created by a dealer acquiring a large block of high quality government bonds where individual bond coupons are attached separately to the bond certificate. These individual bond coupons are in much smaller denominations from the main bond certificate and more affordable for retail investors.

The term strip comes from the fact that the bond coupons are physically clipped and cashed at maturity, separate from the main certificate. The main bond certificate, called the residue, is also sold separately.

To get a better picture of the physical bond certificate, visualize a bond certificate – let’s say a $5,000 bond certificate that has strips of $200 coupons attached to the certificate. Each $200 coupon is clipped and sold separately and each coupon has a different maturity date.

From a tax point of view, Revenue Canada treats the profit received at maturity as interest income on which tax must be paid annually even though you don’t realize a return until the bond matures. For this reason, strip bonds are best held in a tax-sheltered registered retirement savings plan.

Strip bonds react much more strongly to interest rates changes than do regular bonds. During the 1980s when interest rates were in the double-digit range, strip bonds with high compound rates of return were very popular. Much less attention is given to stripped bonds when interest rates are low.