SDL-based STRIPS: Use for duration matching, not for tactical gains

Invest for more than 12 months to enjoy favourable tax treatment

Starting June 12, the Reserve Bank of India (RBI) has permitted the use of the separate trading of registered interest and principal of securities (STRIPS) mechanism for State Development Loans (SDLs). It was earlier allowed for central government securities (G-Secs).

 

“This will enhance price discovery, deepen liquidity, and pave the way for a transparent zero-coupon yield curve in state debt,” says Vishal Goenka, cofounder, IndiaBonds.com.

 

Understanding STRIPS

 

STRIPS involve breaking a standard bond — comprising regular interest (coupon) payments and a final principal repayment — into individual zero-coupon instruments.

 

“These zero-coupon government securities do not pay periodic interest, but are sold at a deep discount and redeemed at face value on maturity,” says Rajkumar Singhal, chief executive officer (CEO) of Quest Investment Advisors.

 

For example, a 10-year SDL with a 7 per cent annual coupon offers Rs 70 each year and Rs 1,000 at maturity. STRIPS convert each Rs 70 coupon and the Rs 1,000 principal into separate tradeable securities.

 

The next important point is how investors earn a return from them. “A Rs 1,000 STRIP maturing in five years might be priced at Rs 700. You will not receive anything during its five-year term, but you will get Rs 1,000 at maturity. The Rs 300 difference is your return,” says Goenka.

 

STRIPS are available across a broad maturity range — from less than a year to over 30 years. “The return on a zero-coupon STRIP typically aligns with the prevailing interest rate at that point on the yield curve. So, a five-year STRIP, for example, offers returns similar to a five-year government or SDL bond,” says Arun Patel, founder and partner, Arunasset Investment Services.

 

While short-term STRIPS are available, holding for over 12 months makes them eligible for favourable long-term capital gains (LTCG) tax treatment.

 

Predictable returns

 

STRIPS suit long-term investors focused on liability matching.

 

Conventional bonds pay interim interest, which needs reinvestment. This exposes investors to reinvestment risk in a falling or volatile interest rate environment.

 

“Being zero-coupon securities, STRIPS provide a fixed payout at maturity. This makes them attractive to investors looking for predictable long-term outcomes,” says Patel.

 

STRIPS are simple to use. “They have a clear, known maturity date and value, which makes it easy to plan for a financial goal using them,” says Goenka.

 

Credit risk is minimal as STRIPS are backed by sovereign entities—either the central or state governments.

 

They also offer tax advantages. If held for over 12 months, they attract an LTCG tax of 12.5 per cent on gains exceeding Rs 1.25 lakh in a financial year. This can result in meaningful tax savings compared to regular interest income, which is taxed at the investor’s marginal slab rate.

 

SDLs, being quasi-sovereign, offer slightly higher yields than G-Secs. “The higher return and relative safety make it appealing to investors,” says Udbhav Shah, founder and sole proprietor, DravyaSiddhi, a mutual fund distributor. He adds that investors can use them to lock in returns in a falling rate environment.

 

No interim cash flow

 

STRIPS carry duration risk. “Being long-duration instruments, STRIPS have high interest-rate sensitivity,” says Singhal.

 

Liquidity is another concern. “Liquidity in STRIPS tends to be lower than in standard government bonds, with fewer buyers and wider bid-ask spreads,” says Patel.

 

Goenka notes that new STRIPS or those with less popular maturities may be harder to exit due to limited trading volumes.

 

The absence of interim cash flows also makes their prices more volatile, according to Goenka. 

 

SDL-based STRIPS carry marginally higher credit risk than central government STRIPS. “Central government STRIPS carry sovereign risk or zero credit risk. State government STRIPS, created from SDLs, carry state government risk. They are very safe but technically carry slightly higher risk than central government STRIPS. Historically, no Indian state has defaulted but the market assigns a small spread to SDLs versus G-Secs. Currently, this spread is about 40 basis points,” says Singhal.

 

Multiple routes for investing

 

Retail investors can purchase STRIPS through the RBI Retail Direct after opening a Retail Direct Gilt account. They may also invest via brokers, the G-Sec segment of exchanges like the National Stock Exchange (NSE) and BSE, and online bond platform providers.

 

The minimum investment through RBI Retail Direct is Rs 10,000. “In the secondary market (through NSE, BSE, or brokers), the minimum lot size may be Rs 10,000 or higher, depending on liquidity,” says Singhal. Goenka adds that the minimum ticket size will be confirmed once STRIPS trading for SDLs formally begins.

 

Allocation strategy

 

Long-term investors should use STRIPS primarily for liability matching (to meet a financial goal that has to be met at a fixed point in the future).

 

They may also be used as a tactical play during a falling interest rate cycle. The RBI governor indicated limited scope for further rate cuts in the June 6 monetary policy announcement. Hence, they are not very attractive as a tactical play now. “The case for STRIPS is less compelling currently than it was 18 months ago. Hence, a lower allocation is advisable,” says Patel.

 

Shah suggests considering alternatives such as small savings schemes, PSU bank deposits, and mutual fund debt schemes (Bharat Bonds and target maturity plans based on PSU, G-Secs or SDL bonds).

   

SDL STRIPS: Are they right for you?

• Suitable for a long-term, conservative investor targeting a certain amount for a specific goal
• Due to lower liquidity, should be comfortable holding till maturity
• Goal longer than 12 months is advisable for favourable tax treatment
• LTCG benefit is more meaningful for those in higher tax brackets
• Those uncomfortable with interim price volatility may avoid
• Not for retirees or those seeking regular cash flows