Introduction section Stripping
According to Italian legislation, it is possible to strip and afterward reconstitute both fixed rate (5, 7, 10, 15, 20, 30 and 50 year BTPs) and inflation-linked (BTP€i linked to the euro area inflation-excluded tobacco) Government Bonds, which are not redeemable in advance and are deposited in the central depository system of Government Bonds (CSD).
The reference regulation is the Decree of the Minister of Economy and Finance n.96718 as of December the 7th 2012, published in the Official Gazette of the Republic of Italy n. 293 as of December the 17th 2012.
Principal is the redemption value of the bond at maturity excluding coupons; in the case of inflation-linked bonds, "principal" is the redemption value of the bond excluding coupons and net of the inflation-indexed component;
Coupon components (also known as Coupon Strips and Coupon iStrips - in case they are stripped from inflation linked issues) are the coupons representing interests payable for the bond;
The hybrid coupon component is the sum of the redemption value of the bond at maturity (principal) together with the last coupon and applies only for fixed rate nominal bonds. This component is due to the introduction of the fungibility between coupons and principal with the same maturity, carried out with the aforementioned Decree currently in force. Therefore, only for fixed rate nominal bond the distinction between coupons and principal is overcome when they have the same maturity.
The inflation-indexed component (hereafter Uplift) is the part of the redemption value of an inflation-linked bond due to inflation accrued from the accrual date to its final maturity; in case of deflation its value is equal to 0 and therefore cannot be negative;
Stripping is the process of separating coupon components and hybrid coupon component in the case of fixed rate bonds while, for inflation-linked bonds, it is the process of separating coupons from the principal and of the inflation-indexed component too;
The Reconstitution of securities is the process of reuniting the previously stripped coupon components (both hybrid and non-hybrid), even if the coupons originate from different bonds, in order to obtain new bonds; for inflation-linked bonds the reconstitution of a bond also includes reuniting the inflation-indexed component and the principal;
Reference inflation is the level of the reference consumer-price index at a given date, calculated as per the Issuance Decrees of the inflation-linked bonds;
The adjustment coefficient is the ratio between 100 and the reference inflation at the initial accrual date of the bond (base index or inflation);
The annual real rate is the annual coupon rate, as defined in the issuance decrees of inflationlinked bonds.
2. WHY SHOULD A BOND BE STRIPPED?
A coupon bond guarantees that the holder will receive a stream of coupons, maturing between the purchasing and selling/redemption date, and the redemption value of the bond at maturity, the latter being the par value increased by the Uplift in the case of inflation linked bonds.
With the coupon stripping operation it is possible to separate a coupon bond into new zero coupon bonds, i.e. originate a number of new zero coupon bonds from a single coupon bond: therefore, for fixed rate nominal bond each single coupon, the hybrid coupon and, in the case of inflation-linked bonds, each single coupon, the Uplift and the principal become separately tradable bonds. These bonds, as confirmed also by the aforementioned Decree (art. 4) become autonomous Government Bonds qualified as zero-coupon bonds.
If an investor, for example, wants to have a Government bond maturing on a specific date (for example 1st February 2018) in their portfolio but is not interested in intermediate coupon cash flows, he can buy stripped components (that is zero coupon bonds) on the secondary market with that maturity date (therefore hybrid coupon component stripped from the BTP 1st February 2018 and/or Coupon Strips maturing on 1st February 2018, stripped from BTPs with coupon cycle February/August and maturity date longer than 1 st February 2018). The investor can also strip the BTP 1st February 2018, take only the final hybrid coupon component and sell the other stripped coupons on the secondary market.
3. HOW IS A GOVERNMENTS BOND STRIPPED AND RECONSTITUTED?
Requests for stripping and reconstituting Government Bonds have to be sent to Euronext Securities Milan (sending a 7A7 message for a stripping and a 7A8 for a reconstitution request) through the Rete Nazionale Interbancaria) by investors that hold an account at its centralized depository. On these, lieu tax is not levied, under Legislative Decree n. 239 of April the 1st 1996 (the so-called “gross subjects”, please refer to the paragraph on tax treatment below).
Pursuant to the aforementioned Ministerial Decree as of December the 7th 2012:
- requests for stripping and reconstituting Government Bonds are admitted for a minimum or multiple nominal amount of 1,000,000 Euro;
- the minimum denomination of the components originated from a stripping process is one Euro cent for the final hybrid coupon components, for the principals, for the Uplift components and for all the other coupon components;
- the wholesale trading venues require minimum trading lots suitable to the characteristics of this type of bonds (art. 3, paragraph 3 of the Ministerial Decree 216/2009).
4. HOW ARE STRIPPING AND RECONSTITUTION OPERATIONS PERFORMED?
Stripping and reconstituting processes are accounting entries, made upon request by entities adhering to the central depository system (CSD) of Government Bonds.
The stripping process gives rise to autonomous Government Bonds qualified as zero-coupon, that can circulate only within the central depository system of Government Bonds1.
For each bond resulting from stripping and reconstitution operations, the issue price is equal to the purchase price, while the issue date is the purchase date. In case more than one purchase of the same bond is made by the same subject the purchase date is the weighted mean date and the purchase price is the weighted mean purchase price. Interest on these bonds is given by the difference between the redemption value and the purchase price. Interest is accrued on a compound basis.
1 Please note that the official figures on the outstanding Public Debt refer to the original issuance of the bonds and therefore do not take into account the stripping operations made on the bonds.
Fungibility between stripped coupons and principal
For fixed rate nominal Government bond, hybrid and non-hybrid coupons, having the same maturity are fungible, irrespective of which initial coupon bond they are stripped from, and therefore have the same ISIN code (i.e. they are zero coupon bonds that will pay one Euro cent at maturity).
For inflation linked bond, the fungibility is admitted only for the coupon components. Moreover, coupons stripped from inflation linked-bonds (Coupon iStrips) are not fungible with coupons stripped from fixed rate nominal bonds.
An ad hoc adjustment mechanism at stripping is required in order to achieve fungibility between Coupon iStrips with the same maturity but originated from different bonds and having a different inflation base index: the so called "adjusted value" of the iStrips is obtained multiplying the semiannual real coupon by the adjustment coefficient (see the definitions above). At the settlement date of a reconstitution operation and/or at maturity of the coupon component, the nominal amount of the Coupon iStrips is multiplied by the reference inflation index divided by 100; in this way consistency in the cash flows of Coupon iStrips with the same date but originated by different underlying bonds and with a different inflation base index is guaranteed.
Here below, the adjustment mechanism of inflation linked bonds at stripping is described:
- C = annual real coupon rate
- TM = minimum strippable nominal amount, i.e. €1,000,000.
- P = nominal amount being stripped (multiple of TM - minimum strippable amount)
- Base Index = euro area HICP ex-tobacco at the initial accrual date (Base Index or initial reference index)
- Coeff.R = Adjustment coefficient = 100/Base Index
- AV = Adjusted Value of the coupon iStrips = Round[Round(C/2*TM*Coeff.R;10)*P/1,000,000;2]
Finally, coupon components (hybrid and not) and the principal of bonds issued with collective action clauses mentioned in the ESM Treaty are not fungible with coupon components (hybrid and bot) and the principal of bonds not issued with the cited clauses.
Payment of the iStrips
At maturity, the cash amount paid on Coupon iStrips is obtained multiplying the coupon component’s “adjusted value” by the reference index at the maturity date divided by 100.
Redemption at maturity of the principal component and uplift
The principal component is redeemed at par.
The cash amount paid at maturity on the Uplift is obtained multiplying the nominal amount of the component by the maximum between 0 and the Indexation Coefficient at maturity date minus 1.
5. TAX TREATMENT
Components originated from stripping processes are new autonomous Government Bonds, qualified as zero coupon bond, and can circulate only within the central depository system of Government Bonds: therefore, fiscal provisions under the Legislative Decree n. 239 of April the 1st 1996, and subsequent amendments2 also apply to the separated components.
Provided that stripping and reconstitution of Government Bonds are admitted for a capital amount equal or multiple of 1,000,000 Euros and that these processes can only be carried out by investors that are not levied with the lieu tax (as stated in art. 2 paragraph 3 of the Ministerial Decree as of December the 7th 2012), the tax treatment, as of Legislative Decree n. 239 of April the 1st 1996, applies to the book-entry Government securities, even when the original components have been stripped, if and only if these components, without any interruption, are deposited on accounts with authorized intermediaries - who are entitled to possibly levy the lieu tax under the above mentioned decree, when needed - and continuously registered to lieu tax exempt entities, both resident or non resident.
To summarize, the lieu tax, under art. 2 of the Legislative Decree 239/96, is not levied on negotiations of stripped components among lieu tax exempt entities that have a deposit with the centralized depository, if those stripped components are deposited, without interruption, with authorized intermediaries. On the contrary, for any other case, and for lieu tax non-exempt entities, that can buy and sell stripped components once originated by a lieu tax exempt entity, provisions on tax treatment as stated in Circular n. 306/E of 23-12-1996 apply.
2 The Legislative Decree 239/96 defines two kinds of fiscal subjects: “net taxpayers” resident in Italy (typically, private individuals and non-commercial entities) that are subject to a lieu tax, currently 12.50%, and “gross taxpayers” (limited companies and nonresident qualified entities, currently the great majority of international investors) to whom no withdrawal at source is made.
Visit the Euronext Securities Milan website to see the date release on coupon stripping.