Treasury STRIPS

What Are Treasury STRIPS?

Treasury STRIPS are bonds that are sold at a discount to their face value. The investor does not receive interest payments but is repaid the full face value when the bonds mature. That is, they mature "at par."

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. These types of bonds are generally known as zero-coupon bonds since they pay no interest or coupon.

Understanding Treasury STRIPS

As the acronym implies, Treasury STRIPS are created when a bond's coupons are separated from the bond. The bond, minus its coupons, is then sold to an investor at a discount price. The difference between that price and the bond's face value at maturity is the investor's profit.

The coupons become separate investments that are sold separately. Treasury STRIPS are issued by the U.S. Treasury and backed by the U.S. government. They were introduced in 1985, replacing previous zero-coupon bond issues that were known as TIGRs and CATS.

All issues from the Treasury with a maturity of 10 years or longer are eligible for the STRIPS process. STRIPS cannot be purchased directly from the government. They can be bought by brokerages for resale to investors.

Example of Coupon Stripping

The process of detaching the interest payments from the bond is called coupon stripping. The coupons become separate securities, with the principal payments due at maturity. No interim coupon payments are made along the way.

For instance, a 10-year bond with a $40,000 face value and a 5% annual interest rate can be stripped. Assuming it originally pays coupons semi-annually, 21 zero-coupon bonds can be created, including 20 semi-annual coupon payments and the bond itself. Each stripped coupon has a $1,000 face value, which is the amount of each coupon. All 21 securities are distinct and are traded separately in the market.

Popularity of STRIPS

STRIPS are a popular choice for fixed-income investors. They have extremely high credit quality because they are backed by U.S. Treasury securities. Since STRIPS are sold at a discount, investors do not require a large stash of cash to purchase them. Assuming the STRIPS are held to maturity, their investors know the precise payouts they'll receive.

There is a robust secondary market for Treasury STRIPS, with individual STRIPS trading at market value until they reach maturity.

STRIPS also offer a range of maturity dates, since they are based on the dates of the interest payments. If an investor wishes to sell a bond prior to its maturity, the market has enough liquidity to accommodate the transaction.

Tax Considerations

Generally speaking, taxes are due on the interest earned each year, even though there is no cash payment until the bond reaches maturity or the STRIPS are sold.

However, this tax can be delayed with a tax-deferred account, such as an individual retirement account (IRA). Each holder of STRIPS receives a report detailing the amount of taxable interest income earned.