Coupon Stripping

Burlesque Bonds! That’s the ticket.

Er...maybe not. Okay, okay...so when a coupon is "stripped," it's removed from the principal of a bond. In this sense, think of a bond as having two components:

1) Interest that it pays in the form of a semi-annual coupon

2) Principal

When the coupon is stripped off of the bond, it's sold separately to investors who are simply buying a stream into the future of interest payments only. They’re not worried about collecting the principal, so in practice, investors will simply do a discounted cash flow model of an interest payment of, say, $6,000 a year for 20 years. This would be a total set of interest payments of $120,000, for which investors will obviously pay less than $120,000 today to discount back for the time value of money, and the risk that the issuer of that bond goes belly up and one day decides it can no longer pay its coupons.

Maybe that number is half of the $120,000, or ⅔, or ¾, or something, but it’s some meaningful discount to the eventual total payout of $120,000, and the calculation of the math looks something like this:

To be all Wall Street-y, the way you would calculate the value here would be to make 20 columns, each representing one year forward of coupon payments, and then discount back by 1 plus the risk-free rate, i.e. what the Fed pays for an analogous time period, plus some premium added in for risk.

For example, if one-year Fed paper pays 2% to discount back the coupons for next year, you might add 100 basis points to the risk-free rate, to then divide that $6,000 payment by 1.03 to the first power.

Skipping forward 5 years, you might note that Federal paper is paying 4% for its 5-year term paper, and because it’s further into the future, you might need 250 basis points added onto the risk-free rate to account for the much higher degree of risk that the company issuing those bonds goes bye-bye.

So in this case, you would discount those 5-year out bonds by that $6,000 payment, then divide by 1 plus the risk-free rate of 4%, plus the risk premium you’ve added on of 2.5%, to come up with a total base of 6.5%, making the calculation 1.065 to the fifth power in the denominator…which then makes the present, risk-adjusted value of $6,000 paid 5 years from now to equal to about $4,590.

So if you keep doing this math for 20 years, you will come up with a fairly sophisticated answer as to how much those stripped coupon payments are worth cumulatively over the next 20 years.

Okay...then what happened to the principal off of which those coupons were stripped?

Well, the principal amount is actually much easier to come by. If it was $100,000, and was yielding 6% for 20 years, then that $100,000 of principal will need to be paid back after 20 years. So calculating the present value of that 20-year-from-now $100k payment is way easier than calculating the myriad coupon payments along the way. In fact, it is only one calculation, and we might note that Federal paper coming due in 20 years is yielding 4.25%...and we’re going to add quite a lot of risk for a bond 20 years forward, because bad things happen to good companies all the time, and we remember that, 20 years previous, Yahoo was the most highly valued company on the planet, and Amazon was worth less than Sears.

So we’re going to add 3.5%, or 350 basis points of risk premium to that 4.25% risk-free rate, to come up with a total discount rate of 7.75%. Now we’re going to calculate what that $100,000 is worth today when it’s paid out 20 years from now by dividing it by the quantity 1 + .0775 to the 20th power.

All that math then says that, twenty years from now, that $100,000 will be about $22,472.

So why would a company strip off coupon payments and principal in the first place? Simply put: because investors were willing to buy that bifurcated, stripped security. Some investors want small payments all the time, and don’t care about a final, large lump-sum payment. Other investors think lovers of zero coupon-style bonds don’t need any cash today, and instead are happy taking one lump payment with a relatively high return delivered waaaaaay at the very end of a couple of decades of interest-loving compoundage.

So yeah…that’s coupon stripping. And as far as stripping goes, this is, uh…about as G-rated as it gets.