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finance a la shmoop what is coupon stripping? burlesque bonds that's the [Burlesque bond dancer on stage]

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ticket or maybe not okay okay when a coupon is

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stripped it is removed from the principle of a bond so in this sense

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think of a bond as having two components there's the interest that it pays in the

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form of a semi-annual coupon and then there's well the principle when the

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coupon is stripped off of the bond it is sold separately to investors who are [Bond sold to investor]

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simply buying a stream of cash flows into the future of interest payments

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only they're not worried about collecting the principal so in practice

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investors will simply do a discounted cash flow model of an interest payment

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of I'll say six grand a year for 20 years which would be a total set of

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interest payments of $120,000 for which investors will obviously pay less than

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that amount today to discount back for the time value of money and the risk

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that the issuer of that bond goes belly-up and one day decides it can no

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longer pay its coupons so maybe that number is half of the hundred twenty [120k halved]

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grand or two-thirds or three-fourths or something like that but it's some

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meaningful discount to the eventual total payout of 120 thousand dollars and

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the calculation of the math when it looks something like this to be all Wall

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Streety and all the way you would calculate the value here would be to

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make twenty columns each representing one year forward of coupon payments and [Columns appear for cash flow calculation]

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then discounting back by one plus the risk-free rate ie what the Fed pays for

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an analogous time period plus some premium added in for risk alright for

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example if one year fed paper pays two percent to discount back the coupons for

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next year well you might add a hundred basis points to the risk-free rate to

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then divide that $6,000 payment by 1.03 to the first power

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cause this bond issuer is not risk free all right skipping forward five years

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well you might note that federal paper at that point is paying four percent for

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its five-year term and because it's further into the future well you might [Power of 5 highlighted in calculation]

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need to discount 250 basis points added on to that risk-free rate to account for

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much higher degree of risk that while the company issuing those bonds goes

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bye-bye so in this case you would discount those five year out bonds by

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that six thousand dollar payment then divide by one plus the risk-free rate of

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4% then you'd add in the risk premium you've added on top that's two and a

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half percent to come up with a total base of six and a half percent making

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the calculation 1.065 to the fifth power in the denominator which

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then makes the present risk adjusted value of six grand paid five years from [Calculation answer appears]

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now to equal about forty five hundred ninety bucks so if you keep doing this

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math for twenty years that's about how long it will take to do this problem you

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will come up with a fairly sophisticated answer as to how much those stripped

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coupon payments are worth cumulatively over the next twenty years so then what

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happened to the principal off of which those coupons were you know stripped

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well the principal amount is actually much easier to calculate if it was a [Man discussing principal amounts of stripped coupons]

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hundred grand while that was yielding six percent for twenty years well then

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that hundred thousand dollars of principal will need to be paid back

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after 20 years once so calculating the present value of that 20 years from now

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hundred grand payment is way easier than calculating the myriad coupon payments

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we just did along the way in fact it's just this one calculation and we might [Man pressing calculator buttons]

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note that federal paper coming due in 20 years is yielding four and a quarter

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percent and we're gonna add quite a lot of risk for a bond 20 years forward

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because well, bad things happen to good companies all the time and we remember

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that about two decades ago Yahoo was the most highly valued company on the planet [Yahoo logo appears]

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and Amazon was worth a fraction of what Sears was worth so yeah bad things so

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we're gonna add three and a half percent or three hundred fifty basis points of

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risk premium each year to that four and a quarter percent risk-free rate to come

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up with a total discount rate of 7 and 3/4 percent okay almost done hang with

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me so now we're gonna calculate what that hundred grand is worth today when

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it's paid out 20 years from now by dividing it by the quantity one plus [New calculation appears]

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0.0775 to the 20th power and all that math then says that the hundred

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grand 20 years from now is only worth about 22 grand and change so why would a

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company strip off coupon payments and principal

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in the first place answer simply put because investors were willing to buy

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that bifurcated stripped security well some investors want small payments all [Investor being paid small payments]

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the time and they don't care about a final large lump sum payment other

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investors think lovers of zero coupon style bonds don't need any cash today [Man in bed with coupon]

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and instead are having taking one lump payment with a relatively high return

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delivered away at the very end of a couple of decades of interest loving

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compoundage-- like you could buy one of those hundred grand thingies 20 years

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from now for only 22 grand today so yeah that's coupon stripping and as far as [Man discussing coupon stripping]

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real stripping goes well this is about as g-rated as it gets people here what [Woman with coupon for head pole-dancing]

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do you think we're running here at shmoop..

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