4. Bond stripping is the practice of buying an issue of treasury securities and

Question

4. Bond stripping is the practice of buying an issue of treasury securities and then selling a collection of zero-coupon bonds such that the payments received from the treasuries exactly cover the payments promised to the buyers of the zeros a) Investment bankers strip bonds because they are able to sell the individual pieces for more than the cost of the underlying treasury securities. Why might certain investors (for example, a pension fund) be willing to pay more for pure discount bonds than for coupon bonds of a similar maturity? Remember, a pension fund pays no taxes on either sort of bond. b) Suppose everyone in the world suddenly become risk neutral. What effect, if any, would this have on an investment bank's ability to make money from bond stripping?

Explanation / Answer

A) Pension fund is specifically long term investor and they invest as per the maturity of their defenite benefit obligation. Strategy is asset liability matching strategy. Pension funds need total value at the end of maturity which will be equal to the pension liability.

Compared to the zero coupon bond, coupon bond has reinvest risk which is reinvestment of the coupons at market interest rate. Due to fluctuation of market interest rate investing the coupons is too uncertain.

B) If everyone in the wolrd become risk neutral, then they will not consider reinvestment risk attached with the coupons of coupon bond. So no one will give price for the reinvestment risk. Investors will be inpreferable between Zero coupon bond and coupon bonds. That means no arbitradge gains. It implies that investment banks will not be able to make money by stripping coupon bonds.

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