STRIPS – Missing Link in Debt Market
Ms. Piyusha Desai*
STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. When a conventional security is stripped into a number of zero coupon securities, which are traded separately, such newly created securities are called STRIPS. A 10-year gilt, for example, can be stripped into 21 zero coupon securities – 20 carrying half-yearly coupons with maturities of 6 months, 12 months, 18 months and so on and 1 carrying final redemption amount with maturity of 10 years. A Rs. 100 crore gilt carrying a coupon of 12% with 10 year maturity has cash flows of 20 semi-annual payments of Rs. 6 crore each and the repayment of principal of Rs. 100 crore after ten years. Each of these 21 cash flows can be treated as a zero coupon instrument which can be traded at varying yields. These 21 instruments are STRIPS of the underlying gilt.
STRIPS, as an instrument of trading, is conceptually very easy to understand. It does not involve complex calculations. Since STRIPS are issued at discount, it is easy to arrive at the yield of these instruments. The maturity proceeds of STRIPS are well known in advance and hence can be used to achieve a desired cash flow. Since these are zero coupon instruments with a single maturity value and do not involve cash flows over a period of time, the investors do not face reinvestment risk. If the STRIPS are derived from gilts, they would also be default risk free.
STRIPS enjoy the facility of fungibility and reconstitution. Fungibilty implies merging of different bonds into some other bond. STRIPS derived from different securities can be funged and traded. This means that while the Principal STRIPS will be distinguished from coupon STRIPS, the Coupon / Principal STRIPS payable on the same day will not distinguishable on the basis of security from which these are derived. Reconstitution implies that a group of STRIPS can be merged from zero coupon instruments back to coupon bearing instrument, such that it has the same cash flows. The facility of fungibility and reconstitution provide the participants arbitrage opportunity between the STRIPS and coupon bearing instruments.
STRIPS in India
Markets for STRIPS are yet to emerge in India. The gilt market in India has the necessary size to make STRIPS a success. The secondary market volumes in gilts were Rs.6,98,146 crore during 2000-2001. Government of India and the Reserve Bank of India (RBI) have repeatedly expressed their intention to develop markets for STRIPS and are preparing ground for the same. CBDT is issuing clarifications to promote issuance of STRIPS. RBI is consolidating outstanding gilts to ensure sufficient volumes and liquidity in any one issue, which would facilitate the emergence of benchmarks and development of STRIPS. The fresh gilts are issued on price basis since 1999 instead of yield basis. To avoid uncertainty about the timing and quantum of primary issues, RBI is announcing a calendar for issue of treasury bills for a whole year. RBI is also working with other market participants to set up a clearing corporation.
However, a few legal clarifications / relaxation are needed for issuance and trading of STRIPS. The Negotiable Instruments Act 1881 does not permit transfer of only a part of the amount appearing to be due on an instrument. Thus, a part of a security, for example, interest component of a security cannot be transferred unless the whole security along with other future interest payments are transferred simultaneously. STRIPS require the principal and the interest coupons to be uniquely identified as distinctive securities. Clarifications are required if the issuance and transfer of STRIPS, even though derived from gilts, would attract any stamp duty and at what rates.
Need for STRIPS
As one underlying security can be converted to 21 zero coupon securities, the breadth of the debt market would expand considerably. Increased supply of securities across maturities would provide a continuous market and consequently improve liquidity.
Measures taken in the past to attract small investors to gilt market have not yielded appreciable results. The introduction of STRIPS in gilts would be a good bait for small investors, as these are comparable to other fixed income instruments which are their favourites.
The participants in the debt market normally purchase the securities and hold till maturity. This results in reduced supply of securities for secondary market activity. Further, some participants like provident Funds bear the reinvestment risk due to the interest receipts every six months. STRIPS would provide a solution to both these problems. Banks can issue STRIPS against the securities held by them. Thus they will earn returns against their investment and also increase the supply the securities to boost the secondary market activity. The Provident Funds can invest in STRIPS, which will mature on the required specified date. Thereby the Provident Funds will be able to invest in gilts as required by law and also not have to bear the reinvestment risk and also achieve the desired cash flow.
STRIPS aid in developing the sovereign zero coupon yield curve, as the discount rates are available across the maturities. This helps in valuation and pricing purposes. The corporates can use these rates for pricing the floaters and also as benchmark for fixing the coupon rates for their issues.
The issuer, Government of India, is in need of funds for longer maturity, while the investors prefer short term papers. The preference of the investor as regards the amount/maturity may not match those of the issuer. STRIPS can allow the issuer to issue securities with long term maturity for any amount and allow stripping of these securities to meet the market appetite for short-term securities in convenient amounts.
Issuing Strips
RBI could issue STRIPS itself. RBI may issue the security in the stripped form. RBI may also issue a security in the normal as well as in the stripped form at the time of the auction itself if requested by the bidder. Also, that part of the issue which has devolved on the RBI could be taken off its books by stripping the coupon and principal payments and auctioning them as various zero coupon securities. The market participants would then be bidding on the basis of a zero coupon yield curve.
Approved entities like Primary Dealers or banks may also be permitted to issue the STRIPS. They could deposit the gilt in a custodian account and then issue a secured promissory note whose maturity date coincides with that of the concerned interest/maturity component of the underlying security. Therefore, even though the receipts thus created are not issued by the government, the underlying bond deposited with the custodian is a debt obligation of the government, so the cash flow from the underlying security is certain and carries a back to back government obligation.
RBI could notify through its press release the securities that are available for stripping and also the issue size. Thus the market will have the information about the securities that are stripped and the date of effect, quantum and other related information.
Trading STRIPS
The STRIPS issued either by RBI or the other approved authorities will have unique identification code like loan code, security descriptor. They could be listed on the exchanges for outright transactions, repos and reverse repos. The trading in STRIPS can be carried out either on negotiated basis or continuous order matching system.
Generally the following convention is followed for calculating price/yield of STRIPS:
100
P = ------
(1+y/2)^((r/s)+n)
Where
P = Price of strip
y = Gross redemption yield
r = Number of days from the settlement date to the next quasi coupon date*
s = Exact number of days in the current quasi coupon period
n = Number of remaining quasi coupon periods after the current period
* Quasi coupon dates occur on the semi-annual cycle defined by the maturity date. For example, a strip maturing on 7th December 2001 would have a quasi coupon dates of 7th June and 7th December each year. A quasi coupon period is defined as the period between consecutive quasi coupon dates i.e. six calendar months, regardless of the nature of first coupon dates. For example, a gilt settling on its issue date (assuming this is not also a quasi-coupon date) will have a quasi coupon period which starts on the quasi coupon date prior to the issue date and ends on the first quasi coupon date following the issue date.
Settling STRIPS