How Bond Stripping Changes Cash Flows but Not Funding Value
Summary
The document explains the apparent puzzle of an issuer selling a coupon bond as separate coupon and principal strips. The question assumes that discounting the principal creates an extra funding burden for the issuer, since the stripped pieces seem to represent two obligations instead of one. The accepted response clarifies that stripping is a repackaging: if the coupon and principal strips together sell for the original bond’s value, the issuer receives approximately the same present value of funding.
A second response notes that zero-coupon financing changes the timing of cash flows. An issuer may prefer a smaller amount upfront in exchange for avoiding periodic coupon payments, while investor demand for zero-coupon securities can support their issuance. These explanations are conceptual and omit details such as pricing conditions, transaction fees, taxes, and issuer-specific financing constraints; the present-value equivalence is described as approximate.
Key ideas
- Stripping separates a bond’s coupon and principal cash flows into distinct securities.
- The combined sale value of the strips should approximately equal the original bond’s value.
- Stripping changes the timing and form of payments rather than inherently eroding funding value.
- Zero-coupon structures can suit issuers that prefer no periodic coupon payments and investors who want principal-focused exposure.
- Fees and market pricing can cause the proceeds to differ from simple present-value equivalence.
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Full text
# Rationale for issuing zero coupon bonds # Rationale for issuing zero coupon bonds I have a conceptual question regarding zero-coupon bonds. Say a bond issuer has issued a bond for funding itself, this bond has been split by the issuer (for simplicity assuming issuer is the same as market maker). The issuer sells the bond at a deep discount to the face value. This discount becomes the capital gains (profit) for the bond holder. The issuer has therefore two obligations: - C-STRIPS in which the issuer is paying coupon payments - P-STRIPS in which the issuer is paying the discount Why would the the issuer undertake two obligations of coupon payments and discounted bond prices? If the bond was not stripped, the issuer would only have one obligation of coupon payments and would get the entire face value as a funding source. But by stripping the bond, the issuer has eroded its funding. What is the rationale for the bond issuer to do so? ## Answer by nbbo2 (score 2, accepted) https://quant.stackexchange.com/a/75741 The stripping does not affect the present value (to a first approximation), if the firm issued a 1 million coupon bond, and it was stripped, the value received from selling the coupon-strip plus the value from selling the principal-strip would be 1 million dollars. It is just a repackaging (minus investment bank fees , of course and possibly plus a small premium paid by eager strip buyers). ## Answer by D Stanley (score 2) https://quant.stackexchange.com/a/75740 The rationale is that the bond issuer gets capital upfront with no periodic payment required. So depending on the use of the proceeds, it may be more beneficial to receive a lower amount upfront in exchange for the freedom from those coupon payments. There may be also some investors that prefer zeros for various reasons, so if there is a demand for these bonds it would be natural to have some supply.
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