Introduction To STRIPS

Traditional bonds and fixed-income securities pay interest according to a set schedule and then return the investor’s principal amount at maturity. However, they are only available as a single security that pays both interest and principal. A new type of bond was eventually introduced that separated the repayment of principal from the interest payments. Separate Trading of Registered Interest and Principal Securities (STRIPS) were created to provide investors with another alternative in the fixed-income arena that could meet certain investment objectives that were difficult to achieve using traditional bonds and notes.

History of STRIPS

STRIPS were first introduced by investment dealers in the U.S. in the 1960s. They were initially created by physically stripping the paper coupons from bearer bonds and selling them as separate securities. The disadvantages of bearer bonds, such as the investor being unable to receive an interest payment if the coupon was lost or stolen, led to issuing STRIPS in electronic book-entry form.

How They Work

As is stated in the acronym, STRIPS are simply bonds that have had the interest payments stripped away and sold separately, while the principal amount is still paid out at maturity. The U.S. government does not issue STRIPS directly to investors in the same manner as treasury securities or savings bonds. Instead they are created by financial institutions such as investment banks, which purchase conventional treasury securities and then strip the interest payments away from the principal to be sold to investors as separate securities with separate CUSIP numbers. However, STRIPS are still backed by the full faith and credit of the U.S. government, even though they have been disassembled. (STRIPS are also sold, issued and backed by many other countries' governments as well.)

Example

The U.S. Treasury issues a 30-year bond with a 3.5% coupon rate. An investment bank purchases $100 million of these securities and peels off the 60 semiannual interest payments of $3.5 million each. The bank then registers and sells each interest payment as a separate security along with the principal repayment to create 61 new securities.

Coupon STRIPS are the bonds created from each interest payment, while principal STRIPS represent the claim to repayment of principal from the original bond. Neither coupon nor principal STRIPS have a coupon rate and are thus considered to be zero-coupon bonds, which are issued at a discount and mature at par value. STRIPS are also created from Treasury Inflation Protected Securities (TIPS) that do not have a set coupon rate and pay a floating interest rate. Because zero-coupon STRIPS do not pay actual interest, their durations are always equal to their maturities. A fixed-rate or inflation-adjusted bond that is stripped must have a face value of at least $100 and can only exceed this amount in increments of $100. A financial institution can also reassemble a STRIP into a whole security if it is able to acquire the principal STRIP plus all the remaining coupon STRIPS.

Tax Treatment

Zero-coupon STRIPS are taxed in a somewhat different manner than most bonds. Traditional bond issuers report the interest that was actually paid on their offerings to investors during the year, but STRIPS do not pay actual interest of any kind. Because STRIPS are issued at a discount and mature at par value, the Original Issue Discount (OID) applies. This requires investors to report phantom interest income that is equal to the increase in the value of the bond for that year. (OID that is less than a nominal de minimus amount may be ignored until maturity, when it would instead be reported as a capital gain.) For each year you the STRIP is held, the cost basis will increase and a capital gain or loss could be generated if the bond is sold at a price different from the cost basis. If the bond is held until maturity, the entire discount will be classified as interest income. Investors who purchased STRIPS on TIPS must also report any inflationary adjustment amount every year. The phantom interest from STRIPS is reported by the issuer on Form 1099-OID; however, this figure cannot always be taken at face value and must be recalculated in many cases, such as when the STRIP was purchased at a premium or discount in the secondary market.

Advantages and Disadvantages

Except for those that are adjusted by inflation, STRIPS always pay out the exact amount of their original coupon or principal amounts at maturity, which makes them ideal funding vehicles for when a definite amount of money is needed at a specific time. However, investors who wish to sell their STRIPS before maturity must often dump them at a loss if they can sell them at all, because the secondary market for these securities is often sparsely traded and sometimes nonexistent. As with other types of bonds, STRIPS can also yield capital gains or losses if they are sold before maturity. However, investors who sell STRIPS before maturity may still have to pay taxes on the OID interest that accrued until the sale date.

Who Buys STRIPS

STRIPS are appropriate instruments for many different types of investors. Many types of institutions buy these securities because of their guaranteed cash flows at maturity. Pension funds, insurance companies and banks all hold STRIPS in their portfolios for this reason. Retail investors often buy them for the same reason. The phantom tax issue can be avoided by purchasing STRIPS inside IRAs and tax-deferred retirement plans, where they can grow until maturity with no tax consequence.

Conclusion

STRIPS provide an alternative to traditional bonds for investors who need to rely on definite amounts of money coming due at a specific future date. Although they post negative cash flows until maturity, they may also provide superior yields to traditional bonds in some cases and will always mature at face value. For more information on these versatile instruments, visit the U.S. Treasury website at www.treasurydirect.gov or consult your investment advisor.