What Are Treasury STRIPS?
Treasury STRIPS are bonds sold at a discount to their face value, repaying investors the full face value upon maturity. As zero-coupon bonds, they do not make interim interest payments, earning their holders a profit from the difference between the purchase price and the face value at maturity.
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. This means that the principal and interest components of a Treasury bond are separated and sold as individual securities.
Key Takeaways
- Discounted Purchase: Treasury STRIPS are sold below their face value.
- Zero-Coupon Bonds: No interim interest payments are made; they mature at par.
- Separate Components: Principal and interest components can be traded as separate securities.
- Financial Institution Requirement: STRIPS can only be held through a broker or financial institution.
- Extended Eligibility: Initially, only long-term bonds were eligible, but now, even shorter maturity notes can be converted into STRIPS.
Delving Deep: How Treasury STRIPS Work
Treasury STRIPS emerge when a Treasury bond’s coupons are detached. The coupons and the principal amount are sold separately. Introduced in 1985, these financial products replaced older zero-coupon bonds and are thoroughly backed by the U.S. government, instilling investor confidence. To purchase STRIPS, investors must use a brokerage, as they cannot be directly obtained from the government.
Historical Milestones of Treasury STRIPS
The Journey:
- 1961: The initial STRIPS, in the form of re-opened bills, were introduced and then discontinued in 1974.
- 1985 Resurgence: The revamped STRIPS program allowed the trading of separate principal and interest components of Treasury bonds with over-ten-year maturities.
- 1997 Expansion: The program extended eligibility to all Treasury notes and bonds, beyond just 10- and 30-year securities.
- 2000 Inclusion: Treasury STRIPS expanded further to include 5-year bonds.
The Mechanism: Coupon Stripping
Coupon stripping decouples the bond’s interest payments from its principal. For instance, a $40,000 face value bond with a 5% annual interest rate and ten-year maturity can be stripped into 21 separate zero-coupon bonds. Each bond and coupon payment is treated as its own tradeable security.
Why Invest in Treasury STRIPS?
Choosing Treasury STRIPS offers several advantages:
- Government Backing: Full faith and credit of the U.S. government.
- Predictability: Clear investment cost and expected payoff.
- Diverse Maturity Dates: Available to fit various investment timeframes.
- Low Initial Capital: Affordable for small investors.
- Secondary Market: Active trading environment ensures liquidity.
- Retirement Accounts: Compatibility with tax-advantaged accounts.
The STRIPS Market Popularity
TREASURY STRIPS remain a favorite for fixed-income investors due to high credit quality and simple investment mechanics. Their discount pricing and predictable payouts, if held to maturity, add to their appeal. There’s also ample market liquidity, providing flexibility even for those looking to sell prior to maturity.
Navigating Tax Considerations
Interest earned from STRIPS is taxable annually, despite not receiving cash payments until maturity. However, investing through tax-deferred accounts, like an IRA, can help delay these taxes. STRIPS holders receive annual reports detailing their taxable interest income.
Related Terms: U.S. Treasury bonds, coupon stripping, fixed-income securities.
References
- US Treasury. “Timeline of Separate Trading of Registered Interest and Principal Securities”.
- MorningStar. “Why Are STRIPS Popular?”
