What Are Strip Bonds?
Traditional finance (“TradFi”) and decentralized finance (“DeFi”) share many parallels. Many TradFI products are being ported over and redesigned in DeFi. In this article, we will discuss bonds and the general categories they lie in. We will then discuss zero coupon bonds and how they are used in strip bonds as a precursor to how they can be used in DeFi to fix the rates on yield bearing tokens.
What Are Bonds?
Bonds are investment securities where an investor lends money to an issuer for a set period of time in exchange for periodic coupons payments (i.e. interest payments) and, on maturity, the payment of a principal amount reflecting the face value of the bond. They are usually issued by governments or companies looking to borrow funds from capital markets. Bonds are widely considered to be a safe investment as compared with stocks, although there are some risks relating to credit risk, interest rate risk and market risk.
Bonds are generally issued via auctions in the primary markets and come with two types of interest rates: fixed and floating.
General Categories Of Bonds
A fixed rate bond is a bond that pays the same level of interest over the entire term of the bond. An investor who wants to earn a guaranteed interest rate for a specified term could purchase a fixed rate bond in the form of a Treasury, corporate bond, municipal bond, or certificate of deposit (CD).
Floating rate bonds on the other hand have a variable coupon that is linked to an interest rate benchmark, such as LIBOR or Euribor (SOFR has replaced the LIBOR since 31 December 2021). For example, the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.
Strip Bonds
One of the major challenges with a variable or floating rate bond is the inability to plan or budget future cash flows which might affect the smooth functioning of an institution or a company.
To give some certainty on floating bonds for payments on future dates, STRIPS were created. STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. STRIPS let investors hold and trade the interest and principal components separately. STRIPS are called “zero coupon” bonds since the only time an investor receives a payment from STRIPS is at maturity.
But what are zero coupon bonds?
Zero Coupon Bonds
A zero coupon bond is a bond with no coupon payments. You can buy a zero coupon bond at a discounted price lower than its face value and then make a profit by redeeming it at maturity for its full face value. For example, a zero coupon bond of $100 face value, with one year maturity and giving a yield of 25%, could be purchased at the discounted price of $80 today. Examples of zero coupon bonds include U.S. Treasury bills, U.S. savings bonds and long term zero coupon bonds.
Zero coupon bonds are generally created from fixed rate bonds by a financial institution separating (“stripping off”) the coupons from the principal. In other words, the coupon payments and the final principal payment of the bond may be traded separately.
How Do Strip Bonds Work?
Strip bonds are debt instruments in which principal and yields (coupon payments) of interest bearing securities or bonds have been removed and are sold separately to investors. These principals and yields are traded as zero coupon bonds and therefore involve no reinvestment risk.
An investor who buys the principal bond receives an amount equal to the face value of the bond when it matures, while those who purchase the yields receive the interest accrued on the zero coupon bond.
For example, let’s imagine a 20-year bond with a face value of $20,000 and a 10% interest rate. A brokerage could purchase a receipt for the bond and strip the principal from its 40 semiannual interest payments. It would then sell to investors 41 separate zero coupon securities, each with different maturities based on when the interest payments on the Treasury bond were due. The zeros would be discounted to the present value using the prevailing interest rate and term to maturity. If the principal unit of $20,000 was discounted by 10% for 20 years, it would sell for $2,973 (ignoring any markup or commissions). Upon maturity, the principal would be worth $20,000, and each of the interest-backed securities would pay $1,000 (one half the annual interest on the bond). The brokerage would use its earnings from its Treasury bond to pay the holders of the STRIPS as they mature.
Just like any other debt security, investors do not have to hold the STRIPS to maturity to cash in. An active secondary market exists on which individual STRIPS may be traded at market value until maturity.
Stripping Yield Bearing Tokens On DeFi
The DeFi space is growing and TVL on multiple chains on DeFi has grown from $0.5B to $217B in the past 2 years. With lending and borrowing being one of the largest markets on DeFi, users are deploying their crypto on lending and staking platforms to earn a yield on top of their existing crypto holding.
The interest rates on DeFi for these products have been very volatile and vary mostly due to the market conditions.
To protect users’ interest, Tempus has developed a similar protocol design to strip bonds that decomposes a yield bearing token into Capital and Yield tokens.
Capital tokens give token holders the right to receive one equivalent unit of the underlying token at maturity. Yield tokens on the other hand give the right to receive the variable yield accrued on the underlying token over the duration of the pool.
Stripping these yield bearing tokens therefore allows users to not only fix their future yield but also manage their treasuries and future cash flow.
Read more to know more about Tempus and how users can fix their yield or earn additional yield on the secondary market!
Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
