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The Money Management Newsletter: GICs and Fixed Income
Strip Bonds - Are they really the investment for you?

"There have been several articles in recent issues of a seniors magazine enthusiastically supporting Strip Bonds. We have fielded a lot of questions from clients on this subject and felt it would be appropriate to clarify some points about this type of investment vehicle."

What are they?

Strip Bonds (sometimes called Stripped Bonds) are created by investment dealers hereby the interest portion of government bonds, Federal or Provincial, are literally stripped from the principal portion. The separated coupons and remaining principal are then sold separately to investors.
For example, let's look at a fictitious $10,000 Government of Canada bond with a coupon of 10% and a maturity date of June 1, 2005. If all of the coupons are stripped off, a buyer of the remaining bond portion will receive only one payment of $10,000 on June 1, 2005 if the bond is held to maturity. There will be no payments of interest before maturity, since the coupons have been sold to someone else.

How is the purchase price determined?

A buyer of the bond described in our example certainly won't pay $10,000 now to receive $10,000 back in the year 2005 without any intervening interest payments. The market price of the bond at any date is really a calculation of its then present value.

The present value is determined by two factors:


1. the length of time to the maturity date (the farther away the maturity date, the lower the present value)

2. the prevailing level of current interest rates (the higher the current level of rates, the lower the present value)

Examples of the effects of variations in yield and maturity period on present value are shown below.

Present Maturity
Yield
Maturity
Value
Amount
Period
$4,631
$10,000
8%
10 years
$3,855
$10,000
10%
10 years
$2,145
$10,000
8%
20 years
$1,486
$10,000
10%
20 years

Whoever holds the bond on June 1, 2005 will receive $10,000 for it. Buyers and sellers of the bond before June 1, 2005 will pay or receive an amount based on the present value at the time of the transaction. The dollar return for the buyer is the difference between the present value paid and the maturity amount. This is treated as interest income.

What does this information mean from an investment standpoint?

Benefits

1) excellent investment for producing compound growth over a specified period of time (yields are locked in at the time of purchase and will hold through maturity - if the bond is held to maturity - makes an ideal product for a self-directed RRSP).

2 ) small amounts of capital can produce substantial maturity payouts

3) 100% government guarantee (federal or provincial) regardless of amount invested

4) Liquid and can be sold at any time

Drawbacks

1) no interest payments prior to maturity and therefore not practical for those requiring a regular income

2) if held outside an RRSP, there is a tax liability each year on the accrued interest portion even though there isn't any interest received (similar to a compound interest GIC)

3) the present value of the bond will fluctuate widely with changes in prevailing interest rates since there are no regular interest payments to stabilize the value. Therefore resale prior to maturity, either voluntary or for estate windups or emergencies, may result in a substantial gain or loss on the original amount paid .

In summary, strip bonds can be a very good investment if held in a RRSP, or for someone who wants to lock in a compound rate of growth and does not mind the annual tax liability and lack of regular income.

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(905) 844-7700

 





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GICs And
Fixed Income

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Look into Government Bonds

Strip Bonds - Are they really the investment for you?

Introducing a GIC for life

The lifetime Term Deposit

What is the best fixed term to invest for with rates so low?

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