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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:

  1. C-STRIPS in which the issuer is paying coupon payments
  2. 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?

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    $\begingroup$ One point of clarification: the discount of a ZC bond is typically treated as interest income over time, not capital gain. $\endgroup$
    – D Stanley
    Jun 1 at 15:13
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    $\begingroup$ @DStanley I think how a ZC bond is treated would depend on the buyer and its actions. For example, if it is a bank who is holding it under the not-for-sale category, then that bank should not recognize the quarterly changes in the bond's valuation over time as interest income contributing to its quarterly US-GAAP earnings. Not sure about the tax treatment though. $\endgroup$
    – Alper
    Jun 1 at 20:48
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    $\begingroup$ For a corporate bond issuer, paying bond coupons may help reduce income tax. I don't think this works for ZC. $\endgroup$
    – Dimitri Vulis
    Jun 1 at 20:49

2 Answers 2

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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).

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  • $\begingroup$ So for the sake of simplicity can we assume that a bond's coupon before stripping is higher than it's coupon after stripping? $\endgroup$
    – Kay
    Jun 1 at 19:20
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    $\begingroup$ Why do you say that? What is the problem/situation you are trying to solve? $\endgroup$
    – nbbo2
    Jun 1 at 22:24
  • $\begingroup$ I am studying bonds and authors introduce stripping of bonds without any context. I want to understand the context and mechanism behind the process. Why would you 1. Go through the hassle of splitting 2. And give a discount on p strip while the issuer could just get the full value of financing (say $1000) without stripping? Because the obligation of full contractual coupon payment still exists. Currently it seems like a disadvantage to the issuer $\endgroup$
    – Kay
    Jun 2 at 7:45
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    $\begingroup$ The corporation (or more likely Governemnt) likes/wants to issue Coupon Bonds, so it issues a Coupon Bond. An Investment Bank sees a business oppty, it buys the Bond and sells the c-strips and p-strips to Insurance Companies and Pension Funds that are eager to buy such things. The Corporation makes Coupon and Principal payments as usual on a coupon bond. The ICs and PFs receive the strip payments. The IB makes a small profit from the ICs and PFs, it may or may not pass some of it back to the issuer. Everyone makes/receives the payments they wanted and agreed to make. Nobody loses. $\endgroup$
    – nbbo2
    Jun 2 at 8:55
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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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  • $\begingroup$ The issuer still has the periodic payment to make in form of the c-strip. So I don't understand how that obligation is avoided? $\endgroup$
    – Kay
    Jun 1 at 21:05
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    $\begingroup$ I must not be understanding the question - I'm talking about ZC bonds in general. $\endgroup$
    – D Stanley
    Jun 2 at 13:54

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