What are Treasury STRIPS
Treasury STRIPS are fixed-income securities sold at a significant discount to face value and offer no interest payments because they mature at par. STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. These zero-coupon bonds come about when the bond's coupons are separated from the bond or note; an investor's return is determined by the difference between the purchase price and the bond's trading value, or face value if held to maturity.
BREAKING DOWN Treasury STRIPS
Backed by the U.S. government, Treasury STRIPS, which were first introduced in 1985, offer minimal risk and some tax benefits in certain states, replacing TIGRs and CATS as the dominant zero-coupon U.S. security. Although you receive no tangible income, you typically still have 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 a governmental agency. The securities can be bought by private brokerages.
The act of detaching the interest payments is called coupon stripping. These coupons become separate securities, with the principal payment due at maturity, with no interim coupon payment.
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 several reasons STRIPS have become a popular investment. They have a very high credit quality since the bonds are backed by U.S. Treasury securities. Since STRIPS are sold at a discount, investors do not need a large stash of cash to purchase the bonds. If STRIPS are held to maturity, investors know their payout.
STRIPS offer a range of maturity dates since they are based on the dates of the interest payments. If an investor wishes to sell prior to maturity, the market is very liquid.
Generally, taxes are due for the interest earned each year, even though there is no cash payment until maturity or when the STRIPS are sold. However, a tax-deferred account, such as an individual retirement account (IRA) and nontaxable accounts, which include pension funds, avoid this taxation. Each holder of STRIPS receives a report detailing the amount of interest income earned.