Treasury STRIPS – How Do they Work?

STRIPS comes from the acronym of “Separate Trading of Registered Interest and Principal Securities”. Treasury notes and bonds can be stripped to repackage their interest and principal payments. Usually, a zero-coupon bond issued by the US treasury is termed as a STRIPS instrument.

Institutional investors like pensions funds, banks, and corporations invest in US Treasuries for low credit risk. These bonds also trade at a discount from their face values. Hence, investors can trade these bonds for profits. However, these bonds are less liquid than other types of bonds.

Definition

Treasury STRIPS are fixed-income debt instruments that come with separate payment arrangements for the principal and interest payments. As a result, investors do not receive regular coupon payments similar to a zero-coupon bond.

These bonds are stripped for their principal and each interest payment into a separate bond. Each bond is traded separately and comes with a different maturity date. The process of separating interest payments and the principal is called stripping. It can be performed with other fixed income instruments as well.

Each coupon payment is treated like a separate bond plus the principal repayment. For instance, if the US treasury issues a 15-year bond termed as STRIPS, it will have 16 separate bonds. It will offer 15 bonds for annual coupon payments and the 16th for the principal repayment on the maturity date.

How Do Treasury STIPS Work?

US government issues US Treasury STRIPS. However, these instruments are not directly accessible to retail investors. Instead, US Treasury offers these bonds through large financial institutes such as banks. These banks then strip these bonds for interest payments and create individual bonds for each coupon payment separately. Once sold, these instruments become marketable securities like other bonds.

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Treasury STRIPS come with the highest credit ratings as the US government backs them. However, retail investors can only invest in these instruments through designated brokers. US government does not directly trade these instruments to retail investors.

Bonds and treasury notes issued by the US government with a maturity of more than 10-years become eligible for the stripping process. Banks and corporations then strip off coupon payments from these bonds and create STRIPS.

Example

Suppose the US treasury issues a bond with a maturity of 20 years. It has a face value of $1,000 and is worth $ 10 million. It comes with a coupon rate of 4% annualized.

A US investment bank purchases the bond worth $10 million and wants to strip off the coupon payments. The bank will create 21 separate bonds out of the one it purchased from the treasury. The new arrangement will now offer 20 bonds worth $400,000 with different maturity dates leading up to the 20th year. The principal repayment will be separate and would become due on maturity at face value.

Important Considerations with STRIPS

Continuing with our example above, the investors can buy any one of the 21 bonds created out of the single one. However, none of these bonds will make any coupon payments. Thus, the STRIPS created this way act like zero-coupon bonds.

STRIPS trade at a discount on the face value. Thus, the incentive for investors is to trade these instruments in the secondary market to make profits. Investors can hold them to maturity to make capital gains as well.

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As STRIPS does not make any coupon payments until maturity, the tax treatment is different from other types of bonds. The interest earned with STRIPS is the difference between discounted bond price and the face value. Each year, the difference would change, and any profit or losses would be adjusted. If the bond is held till maturity, all of the interest earned will be treated as capital gains on investment.

Advantages of STRIPS

US Treasury STRIPS are a popular investment choice for many investors as they offer many advantages.

  • STRIPS are backed by the highest credit rating through the US government.
  • STRIPS offers the lowest call or default risk for investors.
  • Financial Institutes take advantage of secured debt instruments and repackage them to raise capital.
  • Investors can feel secured with safer investments and receive consistent profits.
  • Corporate and retail investors can enjoy a large market of these instruments. Hence, liquidity is not a concern with treasury STRIPS.

Disadvantages of STRIPS

Treasury STRIPS are useful investment instruments for corporate investors. Yet, these instruments offer some disadvantages too.

  • Income generated through STRIPS is taxable. Investors can reduce the taxes by matching them with a tax-deferred instrument like an IRA.
  • STRIPS does carry the interest rate risks for corporate and retail investors.
  • As these instruments offer lower coupon rates, these are not effective investments against rising inflation rates for investors in the long run.
  • STRIPS also carries the reinvestment risk as their prices go down if the interest rates rise sharply.

Final Thoughts

US Treasury STIPS are a type of bond created with separating the principal and interest payments. Each payment then acts as a separate individual bond. STRIPS are backed by the highest credit ratings and offer the lowest default risk. However, the coupon rates on these investments are lower, and profits are treated as taxable income.

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