More than a strip tease for investors
Sunday 29 June 1997
Strips - Separate Trading of Registered Interest and Principal of Securities - are created by splitting up the interest and principal payments of a bond, and trading them as individual zero-coupon securities. It's as if your mortgage company was able to sell off each of the monthly payments you're scheduled to make on your home loan in the coming year, and create a market to trade the payments before you've made them.
The instruments are already available in the American, French, Belgian, Austrian and Dutch markets. As the 1999 scheduled start for a single currency approaches, more European governments are expanding the investment tools available to investors in an effort to keep investor cash in their own debt markets, rather than losing it to the bond market next door.
Germany's strips market begins on 4 July, a move designed to "strengthen the competitiveness of the German financial centre, and with a view to European economic and monetary union", said Graham McDevitt, head of bond strategy at Paribas Capital Markets.
A $100m (pounds 60m) 10 per cent five-year bond can be sliced into six separate bond issues: a series of $10m zero-coupon bonds with maturities ranging from one to five years, corresponding to the interest payments; and a $100m five-year zero-coupon bond, comprising the principal repayment.
Because they transform into non-interest-bearing securities, the bonds have no reinvestment risk with no need for investors to find a home for a stream of income payments. That makes them perfect for investors looking to match long-term liabilities involving one-time payments in the future.
"There are a whole raft of different products that strips will suit down to the ground," said Roy Adams, bond manager at Axa Equity and Law Investment Managers.
"If you're writing a pension policy for someone who wants a lump sum at retirement but doesn't need income until they retire, why not buy a great lump of strips for repayment on retirement?"
From 4 July, Germany will allow stripping of its 6.25 per cent bond due in January 2024, its 6 per cent bond due in January 2007 and its 6 per cent bond due in July 2007. The government has also said it plans to sell additional 30-year bonds in the third quarter, which will carry a 4 July coupon. That puts the potential total market for strippable bonds in Germany at Dm67bn (pounds 23bn) at its inception.
By comparison, the US Treasury market, which has had a strips market since 1985 and is the world's biggest user of the market, has strips worth $229bn, while the French market, Europe's first in 1991, is worth about $35bn.
McDevitt at Paribas said that more than 75 per cent of US fund managers own zero-coupon bonds. "Initially, we suspect that the bulk of domestic investors will remain on the sidelines of the German strips market, partly due to a lack of knowledge," he said.
"We may not buy them straightaway, but they'll certainly end up on our list," said Siegfried Cordes, manager at Credit Suisse Immobilien Investment in Frankfurt. "We are in favour of the extra flexibility that they provide."
The main interest in the German bonds is likely to come from private investors, though insurers and reinsurance companies are also likely to be among the big buyers eventually.
"It's a very difficult situation to estimate," said Helmut Kaiser, an analyst at Deutsche Bank. "We've seen some interest from customers, insurers and reinsurers mainly. Institutional investors also have a big advantage to diversify their portfolio and reduce the risks."
A key feature of strips is a characteristic known as convexity. If yields decline, a bond with a higher convexity typically rises more in price than a low convexity bond, making them the most profitable instrument to own in a rising market.
If yields rise, however, the high convexity bond typically falls less in price. A strip will have a higher convexity than a fixed-interest bond for a given maturity. They also have a higher duration, or sensitivity to interest-rate changes, than interest-paying securities with similar maturities.
"For us, it'll be a very useful instrument if we want to add convexity and duration," said Guy Chalkley, a fund manager at Fleming Investment Management, which has about $8bn in fixed income investment. "It'll be very much a portfolio management tool for us, though a couple of our funds will be able to use it to match liabilities."
In Belgium, which has had a strips market since October 1992, investors said they never really caught on. While the US strips market is actively traded by investors and traders who use strips as part of their trading strategy, exploiting their sensitivity to changes in yield, Belgian investors lock them away.
"The Belgian strip market is mainly for insurance portfolios and pension funds which want to hedge their risks," said Mark Vanbockrijk, a fund manager with Cera Bank in Leuven.
In the UK, where the strips market is expected to begin in August, pension companies are expected to create special investment plans to take advantage of the new strips market.
"You could easily buy a series of zero-coupon strips and build a school fees plan around it, which you could then market directly to retail investors," said Adams at Axa.
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