Debt Securities - Treasury STRIPS

Debt instruments generally consists of both principal and interest payments. When that debt takes the form of an interest-bearing security, the portion that states how much principal is owed is called the corpus, and the portion that specifies interest payments is called the coupon.

The act of separating them is called stripping. A stripped corpus is called a zero-coupon bond. Each coupon corresponds to one specific semi-annual payment, so each coupon can also trade as its own zero-coupon bond. After a registered rep strips a bond, she can sell the zero-coupon bond to one investor and the coupon to another, vastly increasing her trading volume (a good thing for her if she gets a commission on each transaction). STRIPS are zero-coupon T-bonds.

  • STRIP Benefits
    STRIPS are increasingly popular for a few reasons:
    • First of all, they are still T-bonds (in all but the most legalistic sense) which means they are the safest, most risk-free investment possible. The U.S. federal government has stellar credit and a record of never defaulting.

    • These bonds have no call features, so the timing and distribution of bond payments cannot be altered by any foreseeable occurrence.

    • They are sold at a known - and generally deep - discount off a known face value that can be redeemed at a known date, so buyers know exactly how much they will earn from an investment in STRIPS. We demonstrate this benefit in the application on the following page.

    • STRIPS trade actively, and an investor can sell these securities for market price instead of holding them to maturity.

    • Finally, STRIPS can be included in tax-deferred retirement plans.

Look Out!
Though these benefits are attractive, like other bonds, prices for STRIPS, can be highly volatile due to changes in general interest rates.

  • STRIP History
    • Broker-dealers used to create their own zero-coupon securities until Treasury introduced the STRIPS system in 1986.

    • Now brokerages create zero-coupon bonds based on Treasury-specified standards, which removes the slight default risk of the brokerage itself.

Look Out!
STRIPS are still issued and sold by brokerages, so they technically are not T-bonds anymore, but rather securities based on the brokerages\' T-bond holdings.

Creating STRIPS

  • Brokerage firms buy T-bonds through a method called book-entry receipts: in other words, the U.S. Treasury records the firm's ownership of the bonds or notes, but the firm does not actually hold certificates that later need to be redeemed.

  • Based on its book-entry receipts, the firm then strips the principal from the interest and creates zero-coupon securities based on portions, or units, of the principal or interest of the security.

Look Out!
Say a 30-year bond has a face value of $100,000 and an 8% interest rate. A brokerage could purchase a receipt for the bond and strip the principal from its 60 semi-annual interest payments. It would then sell to investors 61 separate zero-coupon securities, (60 coupons plus the principal), with different maturities based on when the interest payments on the Treasury bond were due.

The zeros would be discounted to the present value using the prevailing interest rate and term to maturity. If the principal unit of $100,000 was discounted by 8% for 30 years, it would sell for $9,949 plus markup or commissions. Upon maturity, the principal would be worth $100,000, and each of the interest-backed securities would pay $4,000, or half the annual interest on the bond. A similar discounting to present value would apply to pricing each of those $4,000 coupons, with the first - the one that comes due in six months - being worth $3,849, and the last one - the one that comes due in 30 years - being worth $398.

As we mentioned above, one of the greatest attractions of STRIPS lies in all this slicing, dicing and discounting. A T-bond normally costs $10,000. In the above example, a guaranteed payment for $4,000 in 30 years can be had for under $400.

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