Define Strips Finance

STRIPS, which stands for Separate Trading of Registered Interest and Principal Securities, are U.S. Treasury securities that have been separated into their individual components of interest payments and principal repayment. Essentially, a STRIPS bond is created when an existing Treasury bond is “stripped” of its coupon payments and principal, and each component is then sold separately as a zero-coupon bond.

To understand STRIPS finance, it’s crucial to recognize the anatomy of a traditional Treasury bond. These bonds make periodic interest payments (coupon payments) over their lifetime and return the principal amount at maturity. STRIPS unbundle these two aspects. Investors can purchase either the right to receive a single coupon payment at a specific date in the future or the right to receive the principal repayment at maturity.

The appeal of STRIPS lies in their zero-coupon nature. Since they don’t pay periodic interest, investors buy them at a discount to their face value and receive the full face value at maturity. The difference between the purchase price and the face value represents the investor’s return. This simplifies the calculation of yield to maturity, as there’s no need to reinvest coupon payments.

Here’s how the process works:

• Creation: A financial institution purchases a Treasury bond eligible for stripping.
• Stripping: The institution separates the bond into its individual interest payments and the principal repayment.
• Selling: Each interest payment and the principal is then sold as an individual zero-coupon security (STRIPS).
• Investor Purchase: Investors purchase these STRIPS, knowing they will receive the face value on a specific future date.

STRIPS are particularly popular among investors seeking to fund future liabilities, such as college expenses or retirement. Because the future payment is guaranteed by the U.S. government (the underlying Treasury bond), they offer a relatively safe and predictable way to save for long-term goals. Investors can match the maturity dates of their STRIPS holdings with the dates they need the funds, eliminating reinvestment risk – the risk that future coupon payments will have to be reinvested at lower interest rates.

However, it’s important to note that while STRIPS are generally considered low-risk, they are still subject to interest rate risk. If interest rates rise, the value of existing STRIPS can decline, particularly those with longer maturities. The price sensitivity to interest rate changes is higher for STRIPS than for comparable coupon-bearing bonds. This is because a larger proportion of a STRIPS total return is derived from a single payment far into the future, making it more susceptible to discounting when rates rise. Furthermore, since STRIPS are zero-coupon bonds, all of the interest income is earned at maturity. This means that investors may have to pay taxes on accrued interest income each year, even though they don’t receive any cash until maturity (“phantom income”).

In summary, STRIPS provide a unique and valuable tool for financial planning, allowing investors to precisely match future liabilities with guaranteed, zero-coupon Treasury securities. Their predictable nature and government backing make them attractive for long-term savings goals, but investors should be aware of interest rate risk and the potential for phantom income taxation.