Principal-Only Strips - PO

Categories: Bonds

See: Principal.

Not nearly as sexy and kind of weird as it sounds. A strip refers to the dual stripping of a bond’s principal from its stream of interest payments.

The Enemizer, maker of the highest volume digestive aids on the planet, needs to borrow $40 million for a plug and tubing extrusion factory. It will pay 8% a year interest, or $3.2 million a year for 10 years, after which time it promises to pay back the $40 million it has borrowed.

So there are 2 “streams” here. One is the stream of 10 interest payments of $3.2 million each, or a total of $32 million over a decade. (Discounting back that number, it’s worth a lot less than $32 million today). Then it has a final payment of $40 million in 10 years. And yeah, it’s not really a stream. More like a blop. Or splash, or something. Those 2 entities can be stripped such that a principal-only strip is discounted-to-match-risk-and-opportunity-cost-and-expected-inflation-and-other-stuff. And investors then pay, say, $27.33 million today for that payout of $40 million in 10 years.

Can the payout be diced into pieces? Sure. Like...what about 10 payments of $4 million each year? Great. That stream would be worth more to current investors. Lots of ways to enemize the cat. Or skin it. Or whatever.

Related or Semi-related Video

Finance: What is STRIPS?2 Views

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Finance allah shmoop What are strips Well they're just government

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back zero coupon bonds They pay no interest along the

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way And then at the very end after being sold

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at a meaningful discount to par well they pay far

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and everyone goes away Happy ish All right well strips

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stands for separate trading Registered interest principle of securities strips

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Yeah and not nearly as exciting as you were hoping

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right Well strips became a thing in nineteen eighty five

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as the government zero coupon vehicle of choice Replacing older

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forms of money raising The basic idea was to feed

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and ever more complex hunger among investors wanting different flavors

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of debt food and stripping principle in various forms Help

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to at least partially feed that beast well in this

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case the coupons can be stripped from the principle So

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in the case of say fifteen year paper there are

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thirty one elements of payment or thirty one payments to

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be made where thirty of them are coupons or semi

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annual interest payments And those can be packaged as one

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suite of a product And then there is a final

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payment of principle That's the thirty first flavor there you

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know like baskin robbins you know investors can buy them

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separately or combined as it suits their needs And you

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can imagine having just bought a building which carries a

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tax deductible interest costs via debt procured to buy it

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That interest cost to the company's in one hundred grand

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a month Well in order to defeat ease that interest

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costs five dollar word there The company might also by

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strips where they're just buying the coupons from it for

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an offering that pace a four hundred grand twice a

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year in stripped coupons Well that way eight hundred thousand

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boxes with one point two million owed in those monthly

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pay payments on the building are defused and the company

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only has to stress about the remaining four hundred grand

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to cover their brand spanking new building interest costs Well

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at the other end of the liquidity spectrum a company

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might not need any cash for fifteen years and they're

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happy just getting very safe Us government backed interest in

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buying the principal at a discount and then fifteen years

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later cashing in getting the cash getting back to par

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Well either way it's Nice to have a little bit

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Of cash left at the end of the day Especially

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if you're planning to stop by the zero coupon bondage

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parlor That's A different kind of stripping But we didn't

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go there because we're just doing fifty shades of shmoop 00:02:20.83 --> [endTime] here A while

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