Understanding US Treasury STRIPS Bonds

Understanding US Treasury STRIPS Bonds

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Introduction – what Are Treasury STRIPS?

Bonds called Treasury STRIPS, or Separate Trading of Registered Interest and Principal of Securities, are those whose face value has been slashed. The separation of a bond’s coupons from the bond leads to its formation.

An investor buys the bond for cheap after it has been stripped of its coupons. The investor’s profit represents the difference between that cost and the bond’s face value when it matures.

The bond’s face value is returned back to the investor in full upon its maturity, rather than through interest payment distributions. As a result of their lack of interest or coupon payments, these bonds are frequently referred to as zero-coupon bonds.

In 1961, the very first Treasury STRIPS were rolled out, but those weren’t the same kinds of securities that are now on the market. The first STRIPS were made up of a collection of reopened bills with a due date over a duration of a number of weeks. In 1974, they finally started to disappear.

A new STRIPS scheme was launched in 1985 as a result of modifications made to the tax code, succeeding earlier zero-coupon bond issuance known as Treasury Investment Growth Receipts (TIGRs) and Certificate of Accrual on Treasury Securities (CATS).

This made it possible to segregate bonds with a term of more than a decade into distinct principal and coupon payments that could be exchanged as independent securities. The Treasury set up a provision within the next year for restoring principal and coupon payments into the original securities.

The eligibility was steadily broadened as the new securities gained popularity on the market. The program was boosted in 1997 to include all Treasury notes and bonds instead of only the securities with maturity dates of 10 and 30 years. It was expanded in the year 2000 to include formerly excluded 5-year notes.

The coupons split off into their own investments, which are then sold independently.

Most frequently, STRIPS’ investors are long-term institutional investors who place a high value on secured steady income at maturity, since STRIPS pay investors a set, one-time payment during the maturity date.

Are Treasury STRIPS Government-Backed?

Contrary to popular belief, Treasury STRIPS aren’t directly issued by the Federal Reserve. Instead, the US Treasury issues Treasury STRIPS, with backing from the American government. Government agencies do not sell STRIPS directly to the public since only a financial institution, broker, or dealer who deals in government securities to resell to investors may be used to purchase, hold, sell, and redeem STRIPS.

By using book-entry receipts, these organizations take government securities. Treasury then records a book entry confirming that these entities own the underlying assets, although the actual securities are not dispensed until what is payable to the government is settled.

These book receipts serve as the foundation for a new special purpose vehicle that the investment banks build. Using the bond’s cash flow pattern as a guide, the investment banks then produce unique securities.

However, despite not being issued by the government, STRIPS are still seen as having the US government’s full confidence since there is theoretically no risk of default.

Treasury STRIPS US government
The US capitol. Image by The White House

Treasury STRIPS: Coupon Stripping

The principal and interest of the securities that make up Treasury notes and bonds are divided up into separate holdings. Coupon stripping is the procedure of separating the interest payments from the bond. The coupons split off into separate securities and the principal payments are payable upon maturity. There are no temporary coupon payments necessary during the process.

The principal is the bond’s face value or the sum owed when it matures. Interest, meanwhile, is the recurring interest charge that is payable prior to maturity.                                                                

After splitting, each part can be bought and offloaded as a separate security on the secondary market.

Notes, bonds, and treasury inflation-protected securities (TIPS) are examples of Treasury securities that can be stripped since they have a set principal. On the other hand, you can’t strip bills or floating rate notes (FRNs).

Any par amount in excess of the required minimum of $100 to STRIP must be a multiple of the same amount. 

If the financial institution, broker, or dealer acquires all the extant individual components of the original security, a stripped security could be reconstructed into a single security.

Treasury marketable securities are held on behalf of investors by financial institutions, brokers, and dealers via the commercial book-entry system. All STRIPS are stored in the commercial book-entry platform and remain there when reconstituted since you cannot strip or reconstruct in TreasuryDirect or Legacy Treasury Direct.

Treasury inflation-protected securities principal must be adjusted for inflation and it must be reported along with interest income on STRIPS in the year they are obtained.

Each year, an IRS Form 1099 including information about your taxes will be sent to you by the financial institution, broker, or dealer who carries your STRIPS.

treasury STRIPS purchase
Buying treasury STRIPS. Image by pexels / karolina grabowska

Benefits of Treasury STRIPS

Thanks to the US-government’s backing of Treasury STRIPS, investors who are into safe investments become drawn to these bonds.

Additionally, Treasury STRIPS can be advantageous for an investor who needs a fixed payout at a set period and wants to know precisely how much money will be generated. 

According to standard investment theory, investors under the age of 40 are most likely to gain from concentrating on all-stock investments. As a result, they should probably avoid STRIPS which have lower yields, until they begin to include bonds in their investment basket as they get older.

Treasury STRIPS are very straightforward financial products with obvious expenses and returns. An investor can easily select the STRIPS that perfectly meet the time when they might require cash by selecting one of the several maturity dates available. Investors can better plan for particular objectives thanks to this.

The capital investment needed is only minimal. A STRIP based on bond interest could merely cost a few hundred dollars. The minimum institutional acquisition of Treasury bonds, meanwhile, is at $10,000. Furthermore, they have a thriving secondary market, and it is simple to invest in STRIPS via a tax-advantaged retirement account.

Buying government securities has a number of drawbacks, including a lengthy duration. Investors are frequently discouraged from investing in these assets because of the lengthy lock-in period. Nevertheless, the time frames offered by STRIPS are extremely diverse.

Investors can thus opt to invest in a security that has a maturity of half a year. Such assets are profitable due to the lower term and the US Treasury’s guarantee of the cash flow.

Regular interest is paid on Treasury bonds, but in order to get the same yield over the duration of the bond, this interest must be reinvested until it matures. 

While the bonds are outstanding, it is feasible for the interest rate to slump, which would slow the investor’s total growth rate.

Investors are buying zero-coupon bonds with Treasury STRIPS. They have no reinvestment risk if they retain the asset till maturity because they are aware of the investment value as well as the maturity value and their interest rate is fixed.

STRIPS are available in a variety of forms, and they can be incorporated into retirement schemes. STRIPS will be able to increase tax-free till retirement under the existing tax legislation. There are usually many purchasers for these STRIPS because just a tiny amount of each investor’s money are allocated to debt securities.

Drawbacks of Treasury STRIPS

One of the major downsides of Treasury STRIPS is that purchases must be made through a third party since these bonds are not sold to investors directly. So, you would have to acquire them over the counter from a broker or investment firm.

Treasury STRIPS also offer marginal yields since they don’t pay a high interest rate and are low-risk, zero-coupon Treasury bonds. On top of that, the value of STRIPS in the secondary market could drop if interest rates increase.

Due to the fact that STRIPS are made from long-term Treasury bonds, they are regarded as very low risk investments; but, a surge in interest rates would have a negative impact to the price of STRIPS. If inflation keeps picking up, regardless of how long a bond is kept, its return might not be able to catch up with inflation.

Treasury STRIPS Attractiveness

Investors in fixed-income securities frequently choose STRIPS. Due to the US government’s support, they have a very high credit rating. It helps a great deal that investors don’t need a sizable cash reserve to purchase STRIPS because they are offered at a discount. Investors in STRIPS know the specific dividends they will get, assuming the STRIPS are held until maturity, which adds to the bond’s popularity.

Due to the fact that they are dependent on the timings of the interest payments, STRIPS also provide a variety of maturity dates. Market liquidity is sufficient to allow a transaction to take place if an investor wants to sell a bond before it matures.

Treasury STRIPS Tax Considerations

Treasury STRIPS tax
Do Treasury STRIPS have taxes? Image from Ace-Taf.org

Despite the absence of a cash payout until the bond matures or the STRIPS are sold, taxes are typically required on the interest received per year.

A tax-deferred account, like an individual retirement account (IRA), can postpone this tax. A report outlining the total amount of taxable interest income generated is given to each STRIPS holder.

As is the case with the majority of debt assets and equity, such as dividends, interest generated on Treasury STRIPS is taxed when it is received.

For tax reporting purposes, the so-called phantom income, which is the income corresponding to the growth in bond value over time, must be disclosed.

The income is nevertheless reported as though it had been received even though the investor hasn’t actually realized a gain yet because the bond hasn’t been sold or achieved maturity.

If the STRIPS are disposed before they reach maturity, the accrued original issue discount (OID) interest might be subject to tax on the day of disposal. OID is the term used to describe discount issuances that mature at face value.

Along with exchange-traded funds (ETFs) and mutual funds, tax-deferred accounts like retirement accounts as well as 401(k) plans typically contain STRIPS.

It would be better if you could get professional advice from an accountant to better understand the complexity of the taxation of STRIPS because the underlying government bond may also be a Treasury inflation-protected security (TIPS) or municipal bond.

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Adam is an internationally recognised author on financial matters, with over 548.6 million answers views on Quora.com and a widely sold book on Amazon and a contributor on Forbes.

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