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
Finance allah shmoop What are strips Well they're just government
back zero coupon bonds They pay no interest along the
way And then at the very end after being sold
at a meaningful discount to par well they pay far
and everyone goes away Happy ish All right well strips
stands for separate trading Registered interest principle of securities strips
Yeah and not nearly as exciting as you were hoping
right Well strips became a thing in nineteen eighty five
as the government zero coupon vehicle of choice Replacing older
forms of money raising The basic idea was to feed
and ever more complex hunger among investors wanting different flavors
of debt food and stripping principle in various forms Help
to at least partially feed that beast well in this
case the coupons can be stripped from the principle So
in the case of say fifteen year paper there are
thirty one elements of payment or thirty one payments to
be made where thirty of them are coupons or semi
annual interest payments And those can be packaged as one
suite of a product And then there is a final
payment of principle That's the thirty first flavor there you
know like baskin robbins you know investors can buy them
separately or combined as it suits their needs And you
can imagine having just bought a building which carries a
tax deductible interest costs via debt procured to buy it
That interest cost to the company's in one hundred grand
a month Well in order to defeat ease that interest
costs five dollar word there The company might also by
strips where they're just buying the coupons from it for
an offering that pace a four hundred grand twice a
year in stripped coupons Well that way eight hundred thousand
boxes with one point two million owed in those monthly
pay payments on the building are defused and the company
only has to stress about the remaining four hundred grand
to cover their brand spanking new building interest costs Well
at the other end of the liquidity spectrum a company
might not need any cash for fifteen years and they're
happy just getting very safe Us government backed interest in
buying the principal at a discount and then fifteen years
later cashing in getting the cash getting back to par
Well either way it's Nice to have a little bit
Of cash left at the end of the day Especially
if you're planning to stop by the zero coupon bondage
parlor That's A different kind of stripping But we didn't
go there because we're just doing fifty shades of shmoop 00:02:20.83 --> [endTime] here A while