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.
Related or Semi-related Video
Finance: What is a zero coupon bond?15 Views
Finance allah shmoop What is a zero coupon bond After
all this time our hero remains zero Yeah dude all
right well there was a whole song about him and
your parentsgeneration Just ask him The coupon on a bond
is its dividend or yield payment also known as the
rent paid by the corporation or government or individual who's
Borrowing that money sofa bond has zero coupon Does that
mean the rental of that capital is free Uh no
not at all Isiro coupon bond with par value of
a thousand might sell initially for say seven hundred twenty
dollars iy a big discount to that grand the bonds
interest is on ly paid cumulatively at the very end
when the person who loaned the seven hundred twenty dollars
gets his grand back that's it it's a one time
payment of a thousand bucks so many years later like
a decade of that bond yielding a bit over three
point three percent if you did the math of compounding
well this is what it would look like Note that
the amount owed at the end of the year is
mohr than what was owed the previous year and that
the interest is charged than on that amount Well in
real life these calculations are done twice a year with
bonds that is every six months the interest rates are
charged Zero coupon bonds yield notably more than normal bonds
which pay interests every six months Why Why With zero
coupon bonds yield mohr risk in paying some interest at
least some each six month period Well the bondholders getting
something back along the way and over time the interest
payments can be More than the principal loaned itself So
with zero coupon bonds Well there's Just a one time
payment at the very end So you'd better hope the
person showing you that money doesn't You know just decide
to skip town a week before the principal and interest
combined Or do speaking of which i've got a flight 00:02:00.288 --> [endTime] to catch No
Up Next
What is Coupon Stripping? Coupon stripping is the process of taking a coupon bearing bond and separating the coupons into individual zero coupon se...