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Fixed Income

RBI introduces STRIPS

Not the kind that involves invasive body searches, or certain dance bars.

STRIPS is Separate Trading of Registered Interest and Principal of Securities – basically, taking the interest part of the security and buying or selling each one separately. RBI has now allowed STRIPS to happen in Government Securities from April 1, 2010.

If you look at a government bond there are two parts:

  • Every six months a certain fixed interest (the COUPON) will be paid out. For a Rs. 10,000 “face value” 8.24% bond, every six months there is a payment of Rs. 412.
  • The principal repaid after the term of the bond. A Rs. 10,000 “face value” bond will get back Rs. 10,000 at the end.

Both the above are future cash flows. A ten year, Rs. 10,000, 8.24% bond can be stripped into:

  • One Rs. 10,000 payable after 10 years.
  • One Rs. 412 payable after 6 months
  • One Rs. 412 payable after 1 year
  • One Rs. 412 payable after 1.5 years
  • … etc. (total of twenty such Rs. 412 payments)

So effectively, each of these are a “future” – a promise to pay out some money in the future. And without too much complexity it can be “valued” today.

If I told you, please give me some money today, I will pay you Rs. 500 in six months. You can really like me and say here’s Rs. 500, just pay me back, and that’s good for me. But if you’re the financial type, you will think about the interest you forego by not having that money with you for six months, the risk that I might not repay and so on. And say “Okay, here’s Rs. 426.”

Effectively you are valuing a future payment today. The Excel Formula, for those that don’t give a rat’s ass about detailed explanations, is “PV”; gives you the present value of something that’s in the future, based on whatever interest rate you want to receive.

This PV is thus based on a “Zero Coupon Yield” – meaning you value each instrument based on a single known payment at the end, no coupons in between.

Earlier, only the whole bond could be traded, so you had to use “sum of part” concepts etc. to come to a value. With STRIPS, each coupon payment and the principal can be traded separately. The new regulations allow stripping and reconstitution (the opposite process) to be done in blocks of 1 cr. worth government bonds at a time, and the automated process at NDS (Negotiated Dealing System) will spit out coupon and principal STRIPS of Rs. 100 face value each.

Bloomberg says the STRIPS can only be traded OTC, meaning they won’t come on the NDS-OM screen, so you have to call a dealer, get rates etc. to trade. Not that you will – even if you and I can participate, this is largely an institutional market.  But who knows, if interest rates go to 10% or more…

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