In today’s Finshots, we discuss a unique asset class, STRIPS, and why they have become a preferred choice for insurance and pension funds.

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The Story

The term ‘sovereign bonds’ often pops up in the news. And chances are, you’ve come across it a few times.

Simply put, a sovereign bond is a loan the government takes from investors. In exchange, it pays periodic interest and repays the full principal amount when the bond matures.

That’s how a bond works. Pretty simple, right?

Now, similar to sovereign bonds, large and small companies also issue these debt instruments called corporate bonds. When you invest in these regular government or corporate bonds, you receive periodic interest payments or coupons. But here’s the tricky part: what do you do with those payments?

Investors usually reinvest these payouts. But there’s a catch. If interest rates drop, reinvesting in something like an FD or another bond might not fetch the same high returns as your original bond. This uncertainty is called ‘reinvestment risk’.

And that brings us to zero-coupon bonds. These don’t have this issue because they don’t pay periodic interest. Instead, they’re sold at a deep discount, meaning you pay much less upfront than the bond’s face value. At maturity, you receive the full face value. The difference between what you paid and what you get back is your return.

For example, you might buy a bond with a face value of ₹1,000 for just ₹400. At maturity, say 10 years later, you receive ₹1,000. Your profit comes from the ₹600 difference between what you paid and what you get back.

So yeah, there are no periodic payouts, no reinvesting and, most importantly, no reinvestment risk to worry about. Simple and hassle-free!

But Finshots, why are we talking about this today, you ask?

Well, that's because certain zero-coupon debt instruments called G-SEC STRIPS have been in the news lately. Interestingly, trading in these securities has more than tripled since FY21 and grown more than 600% since FY19 because insurance companies and pension funds have become very fond of them.

Now, before we dive into the reason for this fondness, let’s understand STRIPS bonds.

STRIPS refers to ‘Separate Trading of Registered Interest and Principal of Securities’.

A STRIP bond is a debt security in which the principal amount and coupon payments are stripped apart and sold separately.

For instance, say there’s a 3-year bond with a face value of ₹1,000 and an annual coupon (interest) rate of 5%. If you buy it as a regular bond, you pay ₹1,000 and get ₹50 (5% of ₹1,000) every year for three years, with ₹1,000 itself returned at maturity.

But when converted into a STRIPS bond, this bond is split into four separate parts — three interest payments and one principal payment. Each part is then sold separately at a discount. The first year’s ₹50 interest payment might sell for ₹45 since it matures soon. The second year’s ₹50 might go for ₹40 because it’s slightly further away. The third year’s ₹50 could sell for ₹35 since it takes the longest to mature. And the ₹1,000 principal? It might be sold for, say, ₹700, to be redeemed in 3 years. So, each piece becomes its own little zero-coupon bond.

If you’re wondering why this stripping of securities is needed, the main advantage is that investors can buy or sell them according to their needs, thus gaining flexibility in matching their investment goals without worrying about reinvestment risk.

You see, different investors may want different parts of the bond. Some might need a lower value and lesser duration coupon payment part, while others might want the guaranteed lump sum from the principal. If demand is high for both parts, their combined price in the market can end up being more than the price of the full bond. It’s like selling a pizza as individual slices for more money than the whole pizza.

And how that works in favour of insurance companies and pension funds.

These companies have a pretty straightforward job: collect premiums today to ensure that they can pay insurance claims or pensions years or decades later. As easy as it looks, in reality, it’s a tricky balancing act. They need investments that perfectly match their long-term obligations for all the money they collect.

That’s where STRIPS bonds come into the picture. This structure is perfect for insurers managing long-term liabilities. And this is because it gives them a guaranteed, stable return right when needed. No need to worry about reinvesting annual interest payments at unpredictable rates. It’s predictable, it’s stable and it eliminates guesswork.

There’s another advantage too. STRIPS bonds offer portfolio flexibility. Insurers can select investments with precise maturity dates to match future payouts. Its “set-it-and-forget-it” approach works like a charm for these institutions with long-term goals.

There is another angle as to why insurance firms are keen on government STRIPS. Look, to ensure the safety of policyholder funds, insurers must invest a specific portion of their liabilities (the money they collect from people) in government securities. Life insurers must allocate at least 50% of their total investable funds to government securities, while general insurers must invest 30%.

And no prizes for guessing that fixed-income government securities like STRIPS fit the bill perfectly.

Now, these STRIPS are only issued by the central government in India. However, insurers have recently been nudging state governments to convert their debt into STRIPS.

The reason?

STRIPS issued by states are less liquid, which means a higher risk and also an extra return of about 0.3% to 0.4% over government bonds. That’s a decent return bump for institutional investors like insurers and works perfectly in their favour.

While STRIPS are primarily popular with big players, retail investors can participate, too. They can access STRIPS through brokers or mutual funds specialising in these securities.

But there’s a catch. If market interest rates rise later, the latest bonds with higher yields or coupons might outshine existing STRIPS, thus lowering their resale value. So yeah, STRIPS surely aren’t a one-size-fits-all solution.

That said, the STRIPS market in India is still nascent and will likely take years to mature. It’s a space worth observing to see how it evolves.

Until then…

Note: An earlier version of this story incorrectly described the example of the regular 3-year ₹1,000 bond as a zero-coupon bond with interest. The error has now been corrected.

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