Also known as a zero-coupon bond, a strip bond is a type of bond in which the investor purchases the issue for less than the face value of the investment. Once the bond reaches maturity, the investor is paid the full face value of the bond. During the life of the bond issue, no coupons are issued, which means the investor does not receive any type of periodic interest payments on the principal invested when the security was acquired. Depending on the amount of the original discount price, the eventual return on a strip bond can be attractive to many investors.
Both government entities and corporations sometimes issue strip bond issues as a means of generating funds for a specific project. For example, a municipality may create this type of bond issue for the purpose of funding the construction of a municipal office building. The idea is to sell the bonds for less than the face value and delay repayment of the principal, the face value, or any interest that accrues until the instrument reaches maturity. Typically, the maturity date is set to occur after the building project is completed and tenants are occupying the building. At that point, the funds generated from the leasing of office space can be used to compensate investors, without creating any financial hardship on the municipality.
For investors, the strip bond is often a means of generating an equitable return with relatively little risk. Most bond issues of this type will at least allow investors to recoup the original investment plus the difference between that investment and the face value of the bond. This idea of maturing to the par value provides investors with a good idea of what type of return to expect. At the same time, the terms and conditions of the bond may also call for accruing some interest on the investment. When that is the case, the investor will ultimately receive a return that is greater than the face value of the strip bond.
While a strip bond is considered a low-risk investment, it is important to assess the financial stability of the entity that creates and offers the bond issue. Investors should also determine if the issuer has some type of insurance coverage on the bond issue itself that would allow investors to recoup at least their initial investment should unforeseen circumstances prevent the issuer from honoring the commitment. While rare, factors such as natural disasters or political activities that undermine the stability of a local government could have a negative impact on the ability of the issuer to compensate investors according to the original plan. For this reason, making sure the strip bond issue is properly insured is a smart move.
