Strip bonds are well suited for RRSPs, RRIFs or TFSAs. They offer many advantages, such as certainty when planning for income. Remember, however, it’s best to hold strips inside a tax-deferral plan, otherwise you may incur cash flow problems.
Investment dealers first introduced strip bonds (also know as coupons or zero-coupon bonds) into Canada in 1982. At the right price, strips offer registered plan holders a number of advantages.
Here’s how investment dealers create strips. They buy a large block of high-quality federal or provincial government bonds. They ‘strip’ the semi-annual coupons off each bond. Then they sell the bond and all the coupons to investors like you at a discount to (below) their face values. When the bond and coupons mature, you profit by collecting their face values.
For instance, say your broker sells you a 10-year Government of Canada strip with a yield of 2.35 per cent. You would pay $792.72 today and receive $1,000 in 10 years time. You can calculate the price of this strip as $1,000 [1/1.0235) to the power of 10] = $792.72
Lower prices give you higher yields
The yield you earn depends on the size of the discount off the strip’s face value. For example, pay $600 for the strip and your yield would rise from 2.35 per cent to 5.24 per cent. The price of your strip also reflects the profit taken by the bond desk of the investment dealer, as well as your broker. The estimated commission should be provided to you by your broker before you complete your trade. So it pays to shop around.
Strips offer RRSP, RRIF and TFSA investors a number of advantages. First, government bonds, of course, give you the highest degree of safety. There’s little risk of a loss.
Second, strips reinvest principal and accrued interest at the same yield as when you first bought the strip. This shields you from reinvestment risk (the risk of reinvesting at lower rates). Investors who bought long-term strips when yields were much higher than today will continue to earn this same high yield until the strips mature.
This same reinvestment process means that all of your money works for you all of the time. No money sits idle.
You know exactly when strips mature and precisely how much cash you’ll receive. You can, therefore, plan ahead with certainty. This benefit is particularly important for RRIF investors who must withdraw a certain amount of money each year. Strips give them the cash they need and help to prevent forced sales of investments like stocks at inopportune times.
Strips also come with a wide variety of maturity dates—especially if you buy them outside of RRSP season. This gives you the flexibility to pick the terms-to-maturity that meet your needs.
Keep strips in your registered plans
It’s best to keep strips in your registered plans. Otherwise, each year you’ll pay taxes on interest that you’ll receive only when the strips mature. This can cause cash flow problems for investors who live off of their investment income.
Also, keep in mind that the lower a bond’s interest payments, the more its price will swing as a result of changes in rates. Since strips pay no interest before maturity, they’re the most volatile bonds of all. So buy strips only if you can hold them until maturity.
Time your strip purchases
And be aware it’s best to avoid buying strips in the months of January and February. That’s because during these months most Canadians have a 60-day window of opportunity to make their final RRSP contributions for the previous taxation year. Many Canadian make use of this opportunity by buying strips for RRSPs.
This pushes up the price of strips, which, in turn, reduces their yields. Consequently, you should buy strips outside of the RRSP season, when you compete with few buyers. That’s when you’re likely to get a better yield.
If you plan to buy strips for your RRSP or RRIF, then, it’s best to avoid shopping for them in the months of January and February.
This is an edited version of an article that was originally published for subscribers in the February 2, 2018, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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