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Parts of the Paper (STRIPS)

All investments have a goal. The broadest investment objective, irrespective of the type of investment or asset class used, is the creation of wealth. Postponement of current expenditure to invest in a set of future goals is a more specific reason for investing.

During a person’s working life she depends on cash flows generated from the job, profession, or business. Besides this paying for current living and lifestyle expenses, some portion is set aside towards meeting future goals such as own home, education for children and self, retirement, maybe also a car and dream vacation. These goals come with a timeline. Some of the goals have a desired, but flexible timing, while others such as children’s education and retirement are rigid relative to luxury goals like vacations or negotiable targets like a car or home.

Getting the targeted amount at the exact time it is required is a promise of an investment in a fixed-income product. While many believe that the asset prices drop exactly when you sell to fund your needs, it does not apply to the maturity proceeds on your bond (unless it defaults).

Our fixed-income investments have a promise of exciting times coming from the regulator’s plans to develop a vibrant and liquid secondary market for debt instruments. At the wholesale level, there has been a lot of visible action that has translated to clearer valuations, error-free settlements, larger volumes, and derivatives to provide opportunities both for hedging risks and taking them (by speculating). As the retail investor interest and action spread to the fixed-income secondary market we can expect to see some products and hybrids that are common in developed markets available to us, and easing our investment plans.

The corporate bond market currently enjoys limited liquidity and little sophistication. There is also little corporate paper issuance for the long term. The long-term issuances are mostly by the very safe issuer – the Central Government issuing G-Secs. These are hardly available to the retail investor except through mutual funds due to their large market lot size. Corporate bonds offer higher coupons than government paper (naturally, given higher risk). This could make for attractive investments if access and liquidity are eased.

An additional feature that could make large corporate bond issuances attractive to investors is the ability to match their maturity precisely to the time when the investor needs the funds.

Large projects, especially those in the infrastructure sector, need funding for the long term. It could be difficult to raise funding for these even from investors keen to participate in the project financing as the patience, or the requirement of funds invested may fall short of the maturity of the bond. Or the coupon payments may not be large enough to suit the investor’s requirements. Enter STRIPS!

STRIPS are bonds whose principal and coupon payments are stripped (broken up into individual cash flows each representing a coupon and one for the principal payment) by investment firms or dealers and sold separately to investors. The investor who buys the separated interest or principal (known as the residue) of the bond, receives an amount equal to the value of the payment when it is due. Each of the coupon and principal (residue) is treated as an independent bond and traded as a zero-coupon or discounted bond. The investor can buy the part that matches her goal.

For example, a 10-year maturity bond will have bonds representing coupon payments for every 6 months, thus a 6 month, 1 year, 18 months, and so on till the final maturity of 10 years. Thus the bond would be stripped into 21 smaller bonds, including the larger bond for the maturity of the principal. Such products would widen the availability of bonds to smaller investors and aid their financial planning. And projects would find funding a lot easier with wide participation.

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