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    Offbeat Offerings: Treasury STRIPS

    by Cara Scatizzi

    Offbeat Offerings: Treasury STRIPS Splash image

    STRIPS, an acronym for Separate Trading of Registered Interest and Principal of Securities, turn coupon-paying Treasury bonds into zero-coupon bonds by taking the interest and principal components of Treasury notes and bonds and selling them as separate securities. STRIPS are fully backed by the U.S. government and were first introduced to the public in 1985. While the government does not itself issue zero-coupon bonds with longer-term maturities, these stripped notes and bonds are, in essence, a long-term zero-coupon bond backed by the government.

    How It Works

    STRIPS are fixed-income securities that provide investors with a known payment on a specific future date. They are considered “zero-coupon” securities because the only time payment is received is at maturity; although there is an implied annual rate of interest, all payments are deferred until maturity.

    The Treasury securities are stripped by the Commercial Book-Entry System (CBES), where each interest payment and the principal payment become separate zero-coupon securities. Each component has its own identifying number and can be held or traded separately. The CBES is a multi-tiered automated system for purchasing, holding, and transferring securities.

    For example, a stripped Treasury note with five years until maturity consists of a single principal payment at maturity, and 10 semiannual interest payments. Each of the 10 interest payments and the principal payment become 11 separate securities, each with its own identifying number. These stripped securities are sometimes called coupon and principal STRIPS.

    STRIPS are sold at a deep discount to face value, and an owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity.

    STRIPS components can be reassembled into a fully constituted security in the commercial book-entry system by a financial institution or government securities broker or dealer.

    Types

    Treasury fixed-principal notes and bonds and Treasury Inflation-Protected Securities (TIPS) can be stripped.

    Treasury notes are interest-bearing securities that have a fixed maturity of between one and 10 years. Treasury notes pay interest on a semiannual basis and investors receive the full face value at maturity.

    Treasury bonds have maturities over 10 years and pay interest on a semiannual basis. When a bond matures, the investor receives the full face value. TIPS provide investors with protection against inflation. The principal increases with inflation and decreases with deflation, as measured by the consumer price index. When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater. TIPS pay interest semiannually at a fixed rate.

    The minimum face value in order to strip any of these securities is $100. Any amount stripped above the minimum must be stripped in a multiple of $100.

    How to Trade

    STRIPS are not issued or sold directly to investors, but can only be purchased and held through financial institutions and government securities brokers and dealers. STRIPS can be sold before maturity through the broker that issued the STRIP originally. Securities sold before maturity are subject to price fluctuations and uncertainties, since their values are affected by the general investment market and current interest rates. Because these are zero-coupon instruments, their values fluctuate more when interest rates change than comparable-maturity coupon-paying bonds.

    STRIPS are typically bought for less than their maturity values. The difference between the price paid and the value at maturity makes up the return on investment. Usually the further off maturity is, the greater the discount price is at purchase. And typically, but not always, a longer maturity means an implied higher interest rate.

    Investor Suitability

    STRIPS can add stability to any portfolio because the securities, like all government bonds, are fully backed by the U.S. government. The guaranteed payment at maturity adds to the safety of the investment.

    Zero-coupon bonds are desired by investors who do not want to worry about reinvestment rate risk—that is, the risk that your periodic interest payments may be reinvested at a lower interest rates if interest rates fall after the bond is purchased. The actual total rate of return on any bond assumes reinvestment of interest payments until maturity; reinvesting coupon payments at lower interest rates, therefore, lowers your total rate of return on a coupon-paying bond.

    However, because they are zero-coupon bonds, they have greater interest rate risk than coupon-paying bonds of similar maturity. That is, when prevailing interest rates change, the value of a zero-coupon bond will fluctuate to a greater degree than a similar-maturity coupon-paying bond.

    Zero-coupon bonds are most desirable when a fixed obligation is needed by a particular future date—for example, to meet future tuition payments.

    Tax Consequences

    Any increase in the value of STRIPS must be reported in the year in which it is earned, even if it is not actually received until maturity or until the security is sold.

    Since part of the increase in value of a STRIPS is attributed to annual interest rate payments, even though these payments are deferred until maturity, they are taxed in the year in which they are earned. Therefore, if you own a STRIPS, you may owe annual taxes on it (if held in a taxable account) even though you have not received any actual interest payments.

    Similarly, inflation adjustments to principal on TIPS must also be reported in the year earned. Investors receive a report from the financial institution or broker holding the security listing the amount of interest income earned each year for tax purposes.

    Because of these tax implications, STRIPS investors can benefit from holding these securities in a tax-deferred account.

    The Pros

    Safety
    STRIPS are fully backed by the U.S. government and offer minimal risk.

    Guaranteed Return at Maturity
    Before an investor buys a STRIPS, the interest rate and value at maturity are known. As long as the security is held until maturity, the payment is guaranteed.

    No Reinvestment Rate Risk
    Zero-coupon bonds do not have reinvestment rate risk—that is, because there are no periodic interest payments, you do not have the risk that those payments must be reinvested at a lower rate of interest if rates drop after you purchase the bond. The interest rate you receive on the STRIPS will be your actual total return on the bond, assuming you hold it to maturity.

    The Cons

    Low Return
    As with all fixed-income investments, a guaranteed return means less reward. Typical Treasury securities pay low interest rates relative to similar-maturity corporate bonds.

    Greater Interest Rate Risk
    A STRIPS has a guaranteed value at maturity. However, if the security is sold before maturity, the price can fluctuate based on a number of market factors, but would be most affected by current interest rates. Because all interest payments are deferred until maturity, zero-coupon bonds have the greatest amount of interest rate risk compared to coupon-paying bonds of similar maturity—that is, when interest rates change, the value of zero-coupon bonds will change to a greater degree than a coupon bond of similar maturity.

    Tax Implications
    If you hold STRIPS in a taxable account, you will owe taxes on the implied annual rate of interest even though you have not received any actual payments.

    Additional Information

    TreasuryDirect
    www.savingsbonds.gov
    TreasuryDirect is sponsored by the U.S. Department of the Treasury Bureau of the Public Debt. The site offers product information and research tools for a variety of Treasury securities including STRIPS.



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