Strip bonds carry higher yields than regular bonds and this is why many Canadian investors have been attracted to them. But their total annual return performance can be more volatile than regular bonds. With Canadian interest rates predicted to rise, strip bond investors could be in for a negative surprise of the kind suffered in the last three years by stock investors.

A key element of bonds (common to both regular and strip bonds) is that their price falls as interest rates rise (just as their price rises as interest rates fall). For example, a bond with a 5% annual interest coupon would fetch a lower price when yields in the marketplace are, say, 7% than when they are 5%. (This discussion applies to most federal, provincial and corporate bonds that are traded in the bond market but not to Canada Savings Bonds and provincial savings bonds that are not traded.)

The exact impact from rising rates on a bond’s price depends on the maturity of the bond; the longer the maturity, the greater the impact on price.

The total annual return for a regular bond consists of a combination of the annual coupon payments and the impact of any change in price due to interest rate fluctuations. If interest rates rise sharply and by substantial amounts, the annual coupon may not be enough to offset the resulting lower price. A jump in interest rates from 5% to 7% could easily result in a negative annual total return, especially for bonds of longer maturities.

Here is an example of how it works for regular bonds. Assume the bond has a 5% annual coupon. If yields in the marketplace are 5%, then its price would be $100.00. However, if yields in the marketplace jump overnight to 7%, the price on the bond would immediately drop to $85.23 for a 5-year bond, $81.27 for a 10-year bond, and $76.43 for a 20-year bond. These are declines of 14%, 18% and 23%, respectively, and easily exceed the annual coupon. In this case, the total return over a year (including the coupon) would be negative 9%, 13% and 18%.

A mitigating factor with regular bonds is that the investor is receiving interest (usually semi-annually) and this can be invested at the higher market yields, thereby softening the blow somewhat over a longer time frame.

The same price impact from rising interest rates occurs with strip bonds, but to a greater degree.

Strip bonds are known as such because they are essentially the coupons or principal amount stripped from regular bonds and sold separately. They are also known as zero-coupon bonds because there is no annual coupon payment. The return is completely derived from the change in price, which, if yields are steady, goes up every year towards $100.00 as maturity approaches.

Market yields on strip bonds could be as much as a full percentage point higher than regular bonds for the same maturity and issuer. But with this higher yield comes greater price volatility, with the severity of price fluctuations again dependent on the length of time to maturity.

If, as in the above example, yields in the marketplace are 5%, the price for a strip bond would be $59.19. This price can be expected to gradually rise to $100.00 over the five years. But, if market yields jump to 7% overnight, the price would take a temporary hit to $48.32, a decline of 18%, before resuming its climb towards $100.00.

In the same circumstances of an overnight jump of two percentage points in market yields, the value of a 10-year strip bond would drop by 25% from $46.37 to $34.46, and the value of a 20-year strip bond would decline by 38% from $28.47 to $17.51.

This illustrates the negative impact on a portfolio of a sudden rise in interest rates and why investors should carefully review the potential volatility of strip bonds they may hold in response to rising interest rates. They may be better off in regular bonds, particularly short-term bonds, in a rising interest rate environment.

Investors can do what-if scenario calculations for their portfolios using any of a number of bond calculators available free on the Internet. For instance, TD Waterhouse (at www.tdwaterhouse.com, under “planning” and “investment basics”) has an excellent bond calculator that accommodates using a zero coupon for strip bonds.

For general information on bonds, a good Canadian site is www.ebond.com. It is run by an experienced bond trader, Tim Fussner, who also for a modest fee provides extensive bond quotes and will analyze your bond portfolio.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff