Investing in sovereign fixed income: traditional bonds or strips?
Firstly, what is the difference between strip or traditional bonds?
The difference between a strip bond and a traditional one is that a strip is a zero coupon bond, i.e. it does not pay coupons as these are included in the price. Therefore, strip they have a longer duration. For 30Y treasury bonds the duration or sensitivity to movements in interest rates is just under 20 years, while for strip bonds with the same maturity it is close to 30.
As they do not have coupons, the price paid for strips is much lower than the price that an investor would pay for a traditional bond with the same maturity.
We include the following example for illustrative purposes; figures do not correspond to real bonds.
A 30Y treasury pays an annual coupon of 3.33% and is currently trading at 100.
As a 30Y strip does not pay coupons, it will trade at half the price, at 50. On maturity, i.e. in 30 years, it will trade at 100. Therefore, it will gain 100% from today, offering the same annual return as the traditional treasury bond.
- Strip: 100% gain in 30 years = 3.33% annual
- Traditional: bought and sold at 100 and receiving a 3.33% annual coupon, also offers a 100% gain at 30 years.
Then what are the advantages of investing in strip compared to traditional bonds?
- They have no reinvestment risk: the investor is ensured a yield to maturity in strips. In contrast, when investing in traditional bonds, the investor does not know the rate at which the coupons received will be invested.
- Higher yield if interest rates fall: at times of crisis and when risk assets fall dramatically, sovereign debt will see gains due to its status as a safe-haven asset. Strips are more sensitive to interest rate falls, they will outperform traditional bonds, and therefore offer a better investment opportunity to protect against adverse market scenarios.