Treasury STRIPS

Unlocking the Mystery of Treasury STRIPS: A Guide for Investors

Treasury STRIPS, short for Separate Trading of Registered Interest and Principal of Securities, are a unique form of U.S. bonds that offer investors an alternative to traditional fixed-income investments. In this comprehensive guide, we delve into the intricacies of Treasury STRIPS, exploring their features, mechanics, popularity among investors, and tax considerations.

Deciphering Treasury STRIPS

Treasury STRIPS are bonds issued by the U.S. Treasury, sold at a discount to their face value, and pay the full face value upon maturity. Unlike traditional bonds, investors in STRIPS do not receive periodic interest payments. Instead, the bond is purchased at a discounted price, and the difference between the purchase price and the face value is the investor's profit.

Understanding the STRIPS Process

The process of creating Treasury STRIPS involves separating the bond's coupons from the principal amount. These coupons, representing the interest payments, are then sold as separate securities. Introduced in 1985, Treasury STRIPS replaced earlier zero-coupon bond issues known as TIGRs and CATS. While all Treasury issues with a maturity of 10 years or longer are eligible for the STRIPS process, they cannot be directly purchased from the government and are typically bought through brokerages.

Example of Coupon Stripping

Coupon stripping involves detaching the interest payments from the bond, creating separate securities for each coupon payment. For instance, a 10-year bond with a $40,000 face value and a 5% annual interest rate can be stripped into 21 zero-coupon bonds, each representing a semi-annual coupon payment of $1,000.

Popularity and Benefits of STRIPS

Treasury STRIPS are favored by fixed-income investors due to their high credit quality, backed by the U.S. government. Their availability in the secondary market and a range of maturity dates offer flexibility to investors. Additionally, since STRIPS are sold at a discount, they are accessible to investors with varying capital levels.

Tax Considerations

While taxes are typically due on the interest earned each year, investors can defer this tax by holding STRIPS in tax-deferred accounts like IRAs. Holders of STRIPS receive reports detailing taxable interest income earned.