Gilt Strip

The Central Bank will look at the possibility of permitting gilt stripping after the RTGS and scripless securities settlement system is up and running, opening up the possibility of making long-term bonds more liquid.
ldblquote We will look again at coupon stripping after dealers have got familiar with the system,
dblquote Deputy Governor W. A. Wijewardene says.rn

rnGilt stripping is the process of separating interest coupons from the underlying and trading them separately.rn

rnCentral Bank earlier objected to stripping originally because they could not keep track of individual physical coupons.rn

rnBut Head of Public Debt Department KGDD Dheerasinghe says the new scripless securities settlement system has the facility to track and settle coupons.rn

rnIn the US, coupon stripping received official sanction in 1982, and it was permitted in the UK much later.rn

rnIndia, which has overtaken Sri Lanka as the leader in financial liberalization in the region, authorized stripping and reconstitution gilts in 2001.rn

rnOfficially only primary dealers can strip bonds in India (and Gilt Edged Market Markers in the UK).rn

rnOne of the key advantages of stripping is that it helps develop a true yield curve.rn

ldblquote The yield of an instrument with coupons is calculated based on several assumptions,
dblquote says Ajith Fernando of Capital Alliance. rn

rnldblquote For example we assume that interest coupons is re-invested at the same rate, which rarely happens, but in a zero coupon bond this problem does not arise and we get the real rate.
dblquotern

rnAs a result Sri Lankas yield curve is lquote really correct only up to one year, where it is based on zero coupon treasury bills. Beyond one year it is essentially a lquote probably correct yield curve.rn

rnIf interest-bearing bonds are permitted to trade separately, the individual components (coupons and the underlying bond) then trade as separate deep discount bonds.rn

rnThe first semi-annual payment will behave like a six month treasury bill, the second like a one year bill, while the underlying bond and the last interest coupon will be ten year deep discount bonds.rn

rnIn a country where there is an upwardly sloping yield curve (which is most of the time), dealers can simply arbitrage by buying the long term – bond at a higher rate and then discounting the coupons with shorter maturities at lower rates and make a capital gain without assuming a risk themselves.rn

rnIf the yield curve is inverted, dealers can sell the underlying bond and keep the coupons, or reconstitute the bond from components, and re-sell it.rn

rnAll this increases the liquidity of government bonds, which is the debt management offices of developed countries have been quick to permit the practice.rn

rnThe US treasury originally objected to stripping, because the creation of a series of deep discount bonds allowed investor to claim a tax loss, but legislation was later changed and official sanction given.rn

rnIn some markets, including the US, bonds were also placed under custody, and deep discount instruments issued against the underlying security, that matched the cash flows of individual components.rn

rnldblquote Even in Sri Lanka a dealer can achieve the same effect of stripping by repo-ing the coupons away,
dblquote points out G. Ramanan, Head of HNB Securities.rn

rnBut the practice has not caught on, as the Central Bank officially frowns on stripping.