What if there was an easy way for investors or advisors to invest fearlessly, with no chance of losing the initial capital investment, zero nominal loss, tremendous upside potential, good liquidity and a way to adjust for changes in market fundamentals? Well, there is; and it is the same method used in structured products that guarantee the return of principal.

This system is based on nothing more than a stripped government bond. For example, you could start with purchasing a 20-year Government of Canada strip. On Oct. 31, such a strip was priced at $41.86 per $100 — meaning the initial investment of $41.86 turns into $100 on June 1, 2025. Then, invest the difference of $58.14 in a mutual fund or an exchange-traded fund, a stock or anything else, and the worst possible outcome — assuming that the $58.14 investment collapsed to zero — would be a return of the $100 of capital.

Although there would be no coverage for inflation, the investor would still come out whole in a nominal sense. If the $58.14 remained in cash, the investor would have $158.14; and if it were to grow at 7% per year in an exchange-traded fund, the investor would walk away with a total of $386.96, consisting of $100 from the matured strip and $286.96 from the ETF — not bad for what was a riskless investment.

“This is no different than laddering bonds, but the magical property of a strip, in which you invest the difference between matured value and purchase price, is that there is no vigilance required after purchase,” says Derek Moran, a registered financial planner with the Kelowna, B.C., office of Vancouver-based Macdonald Shymko & Co. Ltd. “If you buy the strip, you can then buy an equity asset such as an ETF and you don’t have to worry, although you could trade the equity portion — or what you have done with the difference — and liquidate it at any time.”

There are some problems with strips, however. Their duration — that is, the amount by which the strip will rise or fall with a corresponding 1% change of market interest rates — approximates the remaining term of the strip. For example, if rates were to rise just 1%, the market price of a 10-year strip would fall by 9.2%. In comparison, the same bond with annual interest payments would lose only 6.8% of its price. It’s a transitory paper loss for the investor who can keep smiling through a storm, but the strip does lock the investor into a single interest rate. This removes all risk of interest rate exposure in a technical sense, because there is nothing the investor can do about changing rates. In reality, a climate of low interest rates trending to higher levels means the investor is trapped and unable to capture a better yield.

The problems of illiquidity and imprisonment in low interest rates can be fixed if the strips are laddered. Combine a Government of Canada strip bond due June 1, 2011, priced at $80.34 per $100; another due Dec. 1, 2016, priced at $62.16 per $100; and a final one, due June 1, 2025, priced at $41.86 per $100; this small stack of strips then acquires the ability to adjust to rising interest rates, the main risk for any holder of investment-grade bonds with no call risk and no default issues. If interest rates are higher at the time of maturity of the first or second strip, the investor can roll it over into a higher-yielding strip or bond, should that be attractive.

The potential to roll into higher rates reduces the interest rate rigidity of the series of strips and generates a compensating return that can remove some or most of the paper loss of the strips before maturity.

The strips, therefore, amount to a hedge against rising interest rates. And the amount of the hedge you create depends on the structure of the stack of strips. If you think that interest rates are about to soar, it would be wise to shorten the strips’ average term to maturity to allow for faster rollovers into higher interest rates. In a deck of three strips, the maturities might be set to three years, five years and seven years. The equity component could be invested in commodities that, historically, rise with and define inflation.

@page_break@If an investor or advisor thinks that interest rates will fall in a persistent fashion over time — a scenario associated with deflation — the strips will gain buying power that will offset any losses in equity investments made with the difference between the matured value and the discounted value of the strips. The investor would stretch out the terms of the strips to maximize gains.

In the worst of all possible strip worlds — persistent stagflation, marked by rising consumer prices and rising interest rates — the package of strips would return the principal eroded by inflation and equities scorched by high interest rates and low economic growth. The investor concerned with stagflation would use a short series of strips and invest the difference in commodities.

The stack of strips amounts to a do-it-yourself structured product, notes Tom Czitron, head of fixed-income and structured products for Sceptre Investment Counsel Ltd. in Toronto. “The investor gets much the same thing as a principal-protected structured product that the dealer creates. He may suffer a yield spread because of the dealer’s profit, but it’s only a one-time transaction. At maturity, redemption at full value is free,” Czitron says.

But committing a sum to a package of strips is a fundamental asset allocation. If the average discount is almost 39% — as it is in the example of the three strips with maturities in 2011, 2016 and 2025 — the investor has really put almost 40% of his or her money into government bonds.

That allocation may not be right for every investor. Typically, older investors tend to prefer higher fixed-income allocations and young investors tend to opt for lower fixed-income allocations. The solution, of course, is to adjust maturities. The older investor will often prefer a higher fixed-income allocation with a short-weighted series of strips, whereas the younger investor will tend to find the lower fixed-income allocation suitable. That can be done by stretching the series weightings to the longest strips, which allows more money to be at equity risk and less committed to the government bond.

Using strip bonds as portfolio insurance works only if the issuer pays on time. Using higher-yielding but less secure corporate bonds will allow more money to be at risk in stocks or to be left in cash. Yet, over time, it is worth far less. In creating an insured portfolio, it pays to buy the best insurance, Moran says: “Stick to quality. You want the best government issues, and nothing less.” IE