NIN 98/20 - Government Strip Bonds - Information Statement, Local Policy Statement 3-43, Blanket Order #91/12 [NIN - Rescinded]

Published Date:	1998-04-24
Effective Date:	1998-04-23

Local Policy Statement 3-43 "Government Strip Bonds" ("LPS 3-43") and BOR#91/12 permit trades in government strip bonds to first time purchasers only if an information statement approved by the Commission or Executive Director is delivered to those purchasers. The current approved information statement is attached to NIN#95/9.

Effective May 1, 1998, the Commission has approved the use of a new strip bond information statement (the "Revised Information Statement") and has revoked, effective July 1, 1998, its approval of the information statement attached to NIN#95/9.

To facilitate the transition, either the information statement attached to NIN#95/9 or the attached Revised Information Statement may be used until July 1, 1998.

On January 2, 1998, the Ontario Securities Commission (the "OSC") published a Notice in the OSC Bulletin adopting a new rule (OSC Rule 91-501) and companion policy regarding strip bonds to replace OSC Policy 1.6 Strip Bonds. Under OSC Rule 91-501, the Director of the OSC intends to accept on May 1, 1998, the effective date of OSC Rule 91-501, the use of the same Revised Information Statement that has been approved by the Commission.

A number of issues relating to trading in government strip bonds remain outstanding. The Commission expects to address these issues in due course after considering results from the OSC’s review of the regulation of debt-like derivatives.

DATED at Vancouver, British Columbia, on April 23, 1998

Joyce C. Maykut, Q.C.
Vice Chair

Ref: NIN#95/9
LPS 3-43
BOR#91/12

This Information Statement is being provided as required by securities regulatory authorities in Canada to describe certain attributes of "strip bonds" and "strip bond packages".

Strip Bonds and Strip Bond Packages

In this Information Statement the term "strip bond" refers to an interest in either (i) the amount payable on account of principal, or (ii) an amount payable on account of interest, in respect of one or more "Underlying Bonds". An Underlying Bond is a debt security issued or guaranteed by the government of Canada, a province or territory of Canada or a foreign country or political division thereof and which pays interest at a fixed rate and at regular intervals. (Please note that: in New Brunswick and Quebec, only strip bonds in respect of Underlying Bonds issued or guaranteed by the government of Canada or a province of Canada are eligible for exemption from the registration and prospectus requirements of the applicable securities legislation; in Manitoba the exemption is limited to Underlying Bonds described in Section 19(2)a of the Securities Act (Manitoba); and in British Columbia the exemption is limited to Underlying Bonds of or guaranteed by the government of Canada or a province of Canada or a country or political division of a country recognized by the British Columbia Securities Commission in an order made under section 46(a)(ii) of the Securities Act (British Columbia).)

A strip bond entitles the holder to a single payment of a fixed amount in the future without the payment of any interest in the interim. The purchase price or present value of a strip bond is determined by discounting the amount of the payment to be received on the payment or maturity date of the strip bond by the appropriate interest rate or yield factor. Strip bonds are therefore different from conventional interest-bearing debt securities and purchasers of strip bonds should be aware of the special attributes of strip bonds as described in this Information Statement. Strip bonds may be purchased in various different forms as described below under "Custodial Arrangements".

In this Information Statement the term "strip bond package" refers to a security comprised of two or more strip bonds which are combined to make up a "bond-like" strip bond package or an "annuity-like" strip bond package. A bond-like strip bond package consists of an interest in the principal amount payable in respect of one or more Underlying Bonds, together with one or more interests in the interest payments to be made on one or more Underlying Bonds, thereby creating an instrument that resembles, in its payment characteristics, a conventional bond. An annuity-like strip bond package differs from a bond-like bond package only to the extent that it does not include an interest in the principal amount payable in respect of one or more Underlying Bonds. Strip bond packages may be purchased in the form of several separate strip bonds or as one security in one of the forms described below under " Custodial Arrangements".

Price Volatility

As with conventional interest-bearing debt securities, the market price of strip bonds and strip bond packages will fluctuate with prevailing interest rates. Generally, the market price of conventional interest-bearing debt securities and of strip bonds and strip bond packages will fluctuate in the same direction: when prevailing interest rates rise above the yield of these instruments, their market price will tend to fall; conversely, when prevailing interest rates fall below the yield of these instruments, their market price will tend to rise.

However, the market price of a strip bond will be significantly more volatile than the price of a conventional interest-bearing debt security with the same credit risk and term to maturity. When prevailing interest rates rise, the market price of a strip bond will tend to fall to a greater degree than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity. Conversely, when prevailing interest rates fall, the market price of a strip bond will tend to rise to a greater degree than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity. The primary reason for such volatility is the fact that no interest is paid in respect of a strip bond prior to its maturity. There is, therefore, no opportunity to reinvest interest payments at prevailing rates of interest prior to maturity.

The table below compares changes in the prices of conventional interest-bearing debt securities and strip bonds. The table shows, on a hypothetical basis, the difference in price fluctuation as a result of fluctuations in prevailing interest rates between, on the one hand, 5-year and 20-year $100 face amount conventional bonds bearing interest at 6% payable semi-annually, and, on the other hand, 5-year and 20-year $100 face amount strip bonds priced to yield 6%. It will be noted that the longer the term to maturity of the bond or the strip bond, the more volatile its market price will be.

Price with Price with
Market Market rate drop % price rate increase % price
priceyieldto 5%changeto 7%change


6% 5
Year Bond $100.00 6.00% $104.38 + 4.38% $95.84 - 4.16%

5 Year Strip
Bond 74.41 6.00 78.12 + 4.99 70.89 - 4.73

6% 20 Year
Bond 100.00 6.00 112.55 + 12.55 89.32 - 10.68

20 Year Strip
Bond 30.66 6.00 37.24 + 21.49 25.26 - 17.61


In contrast to strip bonds, the income stream received on a strip bond package prior to maturity or the final payment date may be reinvested at the then prevailing interest rates. Therefore, the market price of a strip bond package will not be as volatile as the market price of a strip bond with the same credit risk and term to maturity or final payment date. However, it may be more volatile than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity.

Secondary Market and Liquidity

Strip bonds, strip bond packages and Underlying Bonds do not trade in Canada in an auction market similar to that for shares listed on a stock exchange. Instead, strip bonds, strip bond packages and Underlying Bonds trade in dealer or over-the-counter markets similar to those for most conventional debt securities.

Certain strip bonds and strip bond packages that are available in Canada are offered by groups of investment dealers or financial institutions which may make markets for the strip bonds and strip bond packages they offer, although they are not obligated to do so. There can be no assurance that a market for a particular strip bonds or strip bond packages will be available at any given time. In such circumstances, purchasers may have to hold their strip bonds and strip bond packages to maturity or final payment date in order to realize their investment.

The market for Underlying Bonds is more liquid than the market for strip bonds and strip bond packages. Total turnover in Canadian federal and provincial bonds totalled $5.5 trillion in 1997, with trading in Canadian federal bonds accounting for 94 percent of this amount. The average daily turnover of government of Canada bonds amounted to $21 billion in 1997, in proportionate terms approximately equivalent to the average daily turnover of U.S. treasury bonds which is generally considered to be the most liquid market in the world.

Government of Canada bonds with 2, 5, 10 and 30-year maturities (i.e., the so-called benchmark issues) account for most of the trading activity in this market and are the most liquid government of Canada securities. The benchmark issues trade with the tightest bid-offered spread, with spreads widening for securities with different maturities than the benchmark issues. The market for provincial government securities is less liquid than the market for government of Canada securities. Securities issued by the larger provinces with significant borrowing requirements are more liquid than securities issued by the smaller provinces.

Custodial Arrangement

Purchasers may purchase strip bonds and strip bond packages in four forms:

• A deposit receipt or certificate issued by a custodian where the receipt or certificate represents the relevant segregated underlying interest coupon(s) or principal residue(s) held by the custodian (alter-ego receipt).
• A deposit receipt or certificate issued by a custodian where the receipt or certificate represents an undivided interest in a pool of interest coupons or principal residues held by the custodian or in interest or principal payments to be made in respect of one or more Underlying Bonds held by the custodian (non alter-ego receipts).
• A book-entry position created by The Canadian Depository for Securities Limited (CDS) which represents an undivided interest in the relevant interest or principal payment(s) to be made in respect of one or more Underlying Bonds held by CDS.
• In limited circumstances, physical delivery of the actual coupon(s) or residue(s) (in specie).

Each of these forms has different characteristics:

• Alter-ego receipts may entitle the holder to take physical delivery of the underlying coupon(s) or residue(s). If the holder decides to take physical delivery, the holder should be aware of the risks (including the risk of lost ownership) associated with holding a bearer security which cannot be replaced. The holder also should be aware that the secondary market for physical strip bonds may be more limited than for other forms of strip bonds and strip bond packages, due to the risks involved.
• For alter-ego receipts and non alter-ego receipts, registered certificates may be available to the holder on request. Where registered certificates are not available under the custodial arrangements for the strip bond or the strip bond package, the holder should receive periodic statements showing the security position from his or her investment dealer or other financial institution.
• Holders of non alter-ego receipts and book-entry positions are not entitled to take physical delivery of the underlying coupon(s) or residue(s), except in cases where specifically allowed by the custodial arrangements or the rules of CDS, as the case may be.
• Holders of alter-ego receipts, non alter-ego receipts and book-entry positions and holders of physical coupon(s) and residue(s), may be limited in their right to enforce the terms of the Underlying Bond(s) directly against the issuer. Further, such holders may have their rights under applicable custodial arrangements and in respect of the Underlying Bond(s) affected by a specified majority of such holders. Voting rights may be allocated to holders of strip bonds and strip bond packages based on a formula specified as part of the relevant custodial arrangement or as specified in the terms of the Underlying Bond(s). Each purchaser should review the relevant custodial arrangements and the purchaser’s rights thereunder.

The facilities of CDS are available for custody and settlement of strip bonds and strip bond packages for any CDS participant which has deposited the Underlying Bonds with CDS or has taken delivery of the Underlying Bonds through CDS.

In some cases the Underlying Bonds are redeemable or callable prior to maturity. Purchasers of strip bonds or strip bond packages relating to interest payments to be made in respect of Underlying Bonds that are redeemable or callable should satisfy themselves that such interest payments do not relate to interest payment dates that may occur after the Underlying Bond’s earliest call or redemption date.

Canadian Income Tax Summary

The Canadian income tax consequences of purchasing strip bonds and strip bond packages are complex. Purchasers of strip bonds and strip bond packages should consult their own tax advisors for advice relating to their particular circumstances. The following summary is intended to be a general commentary on the attributes of strip bonds and strip bond packages under theIncome Tax Act(Canada) ("Tax Act") and the regulations thereunder ("Regulations") for purchasers who hold their strip bonds and strip bond packages as capital property for purposes of the Tax Act. The summary also comments on the attributes under applicable similar provincial taxation laws.

Qualified Investments

Strip bonds and strip bond packages relating to Underlying Bonds that are issued or guaranteed by the government of Canada or issued by a province of Canada are "qualified investments" under the Tax Act and are therefore eligible for purchase by trusts governed by registered retirement savings plan ("RRSPs"), registered retirement income funds ("RRIFs") and deferred profit sharing plans ("DPSPs").

Annual Taxation of Strip Bonds

Revenue Canada has indicated that purchasers of strip bonds will be treated as having purchased a "prescribed debt obligation" within the meaning of the Regulations. Accordingly, a purchaser will be required to include in income in each year a notional amount of interest, notwithstanding that no interest will be paid or received in the year (see example below). Therefore, these instruments may be more attractive to non-taxable accounts, such as self-directed RRSPs, RRIFs, DPSPs, pension funds and charities, than to taxable accounts.

In general terms, the amount of notional interest deemed to accrue each year will be determined by using that interest rate which, when applied to the total purchase price (including any dealer mark-up or commission) and compounded at least annually, will result in a cumulative accrual of notional interest from the date of purchase to the date of maturity equal to the amount of the discount from face value at which the strip bond was purchased.

For individuals and certain trusts, the required accrual of notional interest in each year is generally only up to the anniversary date of the issuance of the Underlying Bond. For example, if a strip bond is purchased on February 1 of a year and the anniversary date of the issuance of the Underlying Bond is June 30, only five months of notional interest accrual will be required in the year of purchase. However, in each subsequent year, notional interest will be required to be accrued from July 1 of the previous year to June 30 of the subsequent year.

The table below sets out the income tax treatment of a taxable individual investor resident in Canada who purchases a $5,000 strip bond on February 1, 1998 at a total purchase price of $3,742.96. The anniversary date of the issuance of the Underlying Bond is June 30. The strip bond is due on June 30, 2003 (i.e. 5 years and 149 days later) and the investor holds it to maturity. Thus, the effective annual interest rate on a strip bond for the purposes of the interest accrual rules will be 5.5%. The investor’s marginal tax rate (determined after taking into account applicable provincial taxation laws) is assumed to be 51%.

Accrued notional interest for
Base for interest compounding year (i.e. 5.5% of the base for Tax
(i.e. purchase price plus previously interest compounding except liability
Yearaccrued notional interest)in the first year at 51%

1998 $3,742.96 $ 82.71* $ 42.18

1999 3,825.67 210.41 107.31

2000 4,036.08 221.98 113.21

2001 4,258.06 234.20 119.44

2002 4,492.26 247.07 126.01

2003 4,739.33 260.67 132.94

1,257.04

* [(1.055) ^149/365 x $3,742.96] = $3,742.96. February 1, 1998 to June 30, 1998 = 149 days because the investor is not credited with interest for the day of purchase.


In some circumstances the anniversary date of the issuance of the Underlying Bond may not be readily determinable. In these circumstances individual investors may wish to consider accruing notional interest each year to the end of the year instead of to the anniversary date.

A corporation, partnership, unit trust or any trust of which a corporation or partnership is a beneficiary is required for each taxation year to accrue notional interest to the end of the taxation year and not just to an earlier anniversary date in the taxation year.

Disposition of Strip Bonds Prior to Maturity

Upon the disposition of a strip bond prior to maturity, purchasers will be required to include in their income for the year of disposition notional interest to the date of disposition. If the amount received on such a disposition exceeds the total of the purchase price and the amount of all notional interest accrued and included in income, the excess will be treated as a capital gain. If the amount received on disposition is less than the total of the purchase price and the amount of all notional interest accrued and included in income, the difference will be treated as a capital loss. As of the date of this Information Statement, a taxpayer was required to take into account three quarters of the capital gain or loss in determining taxable income.

The table below sets out the income tax treatment for the individual investor in the previous example where the investor sells the strip bond on September 30, 2000 for an assumed sale price of $4,361.31.


Proceeds of disposition $ 4,361.31

Base for calculation of capital gain
· initial purchase price $ 3,742.96
· accrued income for 1998 (see previous table) 82.71
· accrued income for 1999 (see previous table) 210.41
· accrued income for 2000
· to anniversary date (see previous table) 221.98
· to September 30 57.85*4,315.91

Capital gain 45.40

Taxable capital gain (3/4 of capital gain) 34.05

* [(1.055) ^92/365 x $4,258.06] = $4,258.06


Strip Bond Packages

Because a strip bond package consists for tax purposes of a series of separate strip bonds, the interest inclusion rules will be satisfied if an annual notional interest inclusion is determined in respect of each separate strip bond as outlined above. However, the calculation of such annual notional interest inclusion may be very complex. In addition, the calculation may be impossible to perform for individual purchasers to the extent that the anniversary dates of the Underlying Bonds are unknown.

As an alternative, purchasers of strip bond packages may wish to consider accruing notional interest to the end of each year at the internal rate of return or yield of the strip bond package determined by reference to the total purchase price (including any dealer mark-up or commission) and on the assumption that each component of the strip bond package is held to maturity or final payment date. The use of this method may in some circumstances result in a marginally less favourable income tax result to an individual purchaser than the calculation of an annual notional interest inclusion in respect of each separate strip bond comprising the strip bond package.

Upon the disposition of a strip bond package prior to maturity, purchasers will be required to include in their income for the year of disposition notional interest to the date of disposition. If the amount received on such a disposition exceeds the sum of the total purchase price and the amount of all notional interest accrued and included in income, the excess will be treated as a capital gain. If the amount received on disposition is less than the sum of the total purchase price and the amount of all notional interest accrued and included in income, the difference will be treated as a capital loss. As of the date of this Information Statement, a taxpayer was required to take into account three quarters of the capital gain or loss in determining taxable income.

Non-Residents of Canada

Non-residents of Canada for the purposes of the Tax Act who purchase strip bonds or strip bond packages relating to Underlying Bonds issued or guaranteed by the government of Canada or issued by a province of Canada and which were issued after April 15, 1966 will not be liable for income tax in Canada (including withholding tax) on any amounts paid or credited with respect to the strip bonds or strip bond packages if such purchasers do not use or hold the strip bonds or strip bond packages in carrying on business in Canada and their sole connection with Canada is the acquisition and ownership of the strip bonds or strip bond packages.

Impact on Yield-to-Maturity of Dealer Mark-ups or Commissions Paid on Strip Bonds

Dealer mark-ups or commissions on strip bonds are quoted as a fixed amount per $100 of maturity amount of the strip bond purchased. The commission charged is generally not affected by the purchase price of the strip bond. Thus, the commission remains the same for strip bonds with a longer term to maturity and lower purchase price. The commissions quoted by investment dealers for strip bonds generally range between 25 cents per $100 of maturity amount to $1.50 per $100 of maturity amount. Commissions are typically at the higher end of this range for small transaction amounts, reflecting the higher costs of processing a small trade. The commissions generally decline for larger transaction sizes.

The table below illustrates the after-commission yield to an investor in strip bonds with different before-commission yields and with different terms to maturity. All of the yield numbers are semi-annual. For example, a strip bond with a term to maturity of one year, a before-commission yield of 4.5% and a commission of 25 cents per $100 of maturity amount has an after-commission yield of 4.234%. The before-commission cost of this particular strip bond will be $94.72 per $100 of maturity amount while the after-commission cost will be $94.97 per $100 of maturity amount. Similarly, a strip bond with a term to maturity of 25 years, a before-commission yield of 6.5% and a commission of $1.50 per $100 of maturity amount has an after-commission yield of 6.204%. The before-commission cost of this particular strip bond will be $20.21 per $100 of maturity amount while the after-commission cost will be $21.71 per $100 of maturity amount.


Commission Yield before Term to maturity in years and yield after commission
or dealer commission or dealer mark-up
mark-up or dealer _______________________________________________
amount mark-up 1 2 5 10 15 25

4.5%4.234%4.361%4.436%4.460% 4.467%4.469%
$0.25 5.5% 5.229% 5.357% 5.433% 5.456% 5.462% 5.460%
6.5% 6.225% 6.354% 6.429% 6.451% 6.455% 6.449%

4.5% 3.703% 4.083% 4.309% 4.381% 4.401% 4.408%
$0.75 5.5% 4.691% 5.073% 5.299% 5.368% 5.385% 5.382% 6.5% 5.679% 6.062% 6.288% 6.354% 6.367% 6.349%
4.5% 2.915% 3.670% 4.121% 4.263% 4.304% 4.318%
$1.50 5.5% 3.892% 4.650% 5.100% 5.238% 5.272% 5.267% 6.5% 4.868% 5.629% 6.078% 6.211% 6.236% 6.204%

The approximate reduction in annual percentage yield associated with the payment of a specific amount of commission or dealer mark-up may generally be calculated as follows:
where

MA is the maturity value of the strip bond.
A prospective purchaser or seller of a strip bond is invited to compare the yield to maturity of the strip bond, calculated after giving effect to any applicable dealer mark-up or commission, against the similarly calculated yield to maturity of a conventional interest bearing debt security. Prospective purchasers or sellers are invited to inquire about the dealer’s bid and ask prices for the subject strip bond.

April, 1998