Many people rely upon professional managers to oversee their investments. Their own monitoring system is restricted to looking at the total market value of the portfolio on their monthly statement. If it goes up, things must be all right; if it goes down, they grumble about their advisor or the excessive riskiness of investing. However, some understanding is necessary before the panic button is hit.
Many people have strip bonds (also known as “Coupon Canada” or “Sentinel”) in their portfolios, particularly within an RRSP. Imagine an RRSP portfolio which is heavily weighted with interest-bearing investments. Imagine further that the portfolio exclusively consists of strip bonds.
“Strips” earn interest income, but in a different fashion to other bonds. A regular bond typically pays interest usually on a semi-annual basis. The difference between its redemption proceeds and what was paid for it is a capital gain (or loss) which is subject to favourable tax treatment. This would also be true if it was sold before maturity.
The strip, however, does not pay interest while you hold it. Instead, the difference between its redemption proceeds and what was paid for it is the interest. When you buy the strip, it is priced to deliver a certain yield to maturity. Each month, the value of the strip moves in a progression towards its redemption value (“maturing value”). However, each month on your statement, the strip is “priced to market”, based upon prevailing interest rates. The market value of the strip is subject to the phenomenon described in the “Prices and Yields” article in the Library. As a result, you may see this market value actually decline from one month to the next. This implies that you have “lost money“. In fact, the strip continues to earn money at the yield-to-maturity rate. The decline in market value is unrealized as long as you continue to hold the bond. In fact, if you hold the bond to maturity, the loss will never be realized.
It is possible to have a capital gain or loss from a strip, but only if you sell it before maturity. This is a trickier calculation wherein you must determine the hypothetical proceeds based upon the implicit yield to maturity, and compare this to the actual proceeds on sale. The difference is the capital gain (or loss).
Now… about the yield to maturity. Consider a strip described as follows: $5875 CPN CDA 11.75% 1OCT93. This does not mean that the investment is earning 11.75%!! Rather, this describes the bond from which the October 1, 1993 interest payment has been separated (“stripped”). Think of it as the name of the investment. The bond itself is paying 11.75% (and it may sell at a discount or premium to do so). To calculate the rate of return on the strip itself, you must compare the redemption proceeds ($5875 in the example) and the purchase price and use present value tables. For instance, if this strip was purchased in August 1988 for $3560, the annualized rate-of-return to maturity is approximately 10.2%.