What are Treasury STRIPS

Treasury STRIPS are fixed-income securities that are sold at a significant discount to face value, but don't offer interest payments, due to the fact that they mature at par. STRIPS, which is an acronym for Separate Trading of Registered Interest and Principal of Securities, are zero-coupon bonds that come about when the bond's coupons are separated from the bond or note. With these instruments, an investor's return is determined by calculating the difference between the purchase price and the bond's trading value (face value) if held to maturity.


Treasury STRIPS

Breaking Down Treasury STRIPS

Backed by the U.S. government, Treasury STRIPS, were introduced in 1985, in an effort to offer minimal risk and some tax benefits in certain states. In this way, STRIPS replaced TIGRs and CATS, as the dominant zero-coupon U.S. security.

Although STRIPS investors don't receive tangible incomes, they nevertheless are obligated to pay federal income tax on the bond's accretion for the year. 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 Federal Reserve or any other governmental agency. However, these securities can be bought by private brokerages.

Key Takeaways
--STRIPS an acronym for Separate Trading of Registered Interest and Principal of Securities.
--Treasury STRIPS are fixed-income securities that are sold at a pronounced discount to face value,
--STRIPS don't offer interest payments, because they mature at par.
--STRIPS are zero-coupon bonds that arise when the bond's coupons are separated from the bond or note.

Coupon Stripping

The act of detaching the interest payments from a bond is called "coupon stripping". These coupons become separate securities, with the principal payment due at maturity, with no interim coupon payments 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. This includes the 20 semi-annual coupon payments. Each stripped coupon has a $1,000 face value, which is the amount of each coupon. There is also a bond created from the principal payment at maturity. All 21 securities are distinct and trade in the market.

Popularity of STRIPS

There are numerous reasons why STRIPS have become a popular investment option. Chief among them, is the fact that they have an extremely high credit quality, because these bonds 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. If STRIPS are held to maturity, investors know the precise payout they'll receive..

STRIPS are likewise attractive to investors because they offer a range of maturity dates, since they are based on the dates of the interest payments. If an investor wishes to sell his position prior to the bond's maturity, the market has enough liquidity to accommodate such a 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 until the STRIPS are sold. However, a tax-deferred account, such as an individual retirement account (IRA) and nontaxable accounts like pension funds avoid this taxation. Each holder of STRIPS receives a report detailing the amount of interest income earned.

[Important: There exists a robust secondary market for Treasury STRIPS, where individual STRIPS trade at market value until they reach maturity.]