What it means
A conventional government bond pays interest twice a year and repays its face value at the end. CATS were created by holding such bonds in a trust and issuing separate certificates against each future payment, a process known as stripping.
Each certificate was a single promise of one fixed amount on one fixed date. The appeal was certainty.
An investor who needed exactly $100,000 in ten years could buy a certificate maturing then and know the precise amount and date, with no coupons to reinvest at unknown future rates. That removed reinvestment risk, which is the risk that interest received early has to be reinvested at a worse rate than the original bond offered.
The entire return came from the gap between the purchase price and the face value, so the price was simply the face value discounted back at the agreed yield. Longer-dated certificates traded at very deep discounts, which made them highly sensitive to interest rate movements.
A small rise in market yields produced a large fall in the price of a long-dated strip. CATS were a proprietary product of one dealer, and competitors launched their own branded versions with similar names, which fragmented the market and limited liquidity.
The US Treasury later introduced an official stripping programme, commonly known as STRIPS, which did the same job with government backing and a unified market, and the branded products faded away. The concept is what endures rather than the product name.
Zero coupon government strips remain a standard tool for pension schemes and insurers matching known future payments, and anyone who meets the term CATS in older material is reading about the ancestor of today's STRIPS market.
In practice
Real-world examples.
Example
A pension scheme owes a known lump sum of $5,000,000 to a closed group of members in twelve years. It buys zero coupon government strips maturing in that year, removing any doubt about the amount available on the date it is needed.
Example
A family wants to fund a child's university costs beginning in eight years. It buys a ladder of strips maturing in each of four consecutive years, so each year's fees arrive as a known amount without needing to sell anything at an uncertain price.
Example
A bond trader expects long-term interest rates to fall sharply. She buys long-dated zero coupon strips rather than conventional bonds because their price is far more sensitive to yield changes, which magnifies the gain if she is right and the loss if she is wrong.
Formula
Calculation
Price = Face Value / (1 + Yield) raised to the power of the number of years to maturity
Simple Annual Accrual = (Face Value - Purchase Price) / Years to Maturity
An investor buys a certificate with a face value of $100,000 maturing in ten years and pays $60,000 for it. The total gain over the life of the holding is $100,000 - $60,000 = $40,000, and on a simple basis that is $40,000 / 10 = $4,000 of accrual a year.
The compound return is the more meaningful figure. The price grows from $60,000 to $100,000 over ten years, a multiple of $100,000 / $60,000 = 1.667, which works out at a compound annual yield of about 5.2%. Note that tax authorities generally treat the annual accrual as taxable income even though no cash is received until maturity, so the holder may owe tax each year on money not yet in hand.Case study
Seen in the real world.
Westvale Teachers Trust is an illustrative, entirely fictional retirement fund used here to show the appeal and the catch. The trust knew it owed $50,000,000 in benefits spread over a four-year window starting fifteen years out, and its investment committee disliked depending on reinvesting coupon income at unknown future rates.
It built a matching portfolio of zero coupon government strips maturing in each of those four years, paying roughly $22,000,000 in total for certificates with a combined face value of $50,000,000. The cash flows matched the liabilities almost exactly, and the committee stopped worrying about reinvestment altogether.
The catch appeared in the interim reporting. In this fictional case market yields rose by just over one percentage point in a single year and the value of the strips fell by around 15%, prompting difficult questions from trustees who had been told the holding was risk free. It was free of reinvestment risk and of default risk, and it was never free of price volatility along the way.
Watch out
Common mistakes.
- Assuming a zero coupon government security has no risk at all. It removes default and reinvestment risk, but its market price swings more sharply with interest rates than almost any conventional bond.
- Expecting no tax bill until maturity. The annual accrual is normally treated as taxable income in the year it arises, which can create a cash cost long before any cash is received.
- Confusing the branded 1980s products with the official programme. CATS was one dealer's version, while the government-run STRIPS market replaced those branded issues with a single standardised one.
Questions
People also ask.
Why would anyone buy a security that pays no interest?
Because the return is built into the discounted purchase price, and the single known payment at a known date is ideal for matching a known future obligation.
Are CATS still issued today?
No, they were superseded by the official Treasury stripping programme, and the term now appears mainly in older textbooks and historical market discussions.
How is the yield on a strip calculated?
By working out the compound annual rate that grows the purchase price to the face value over the remaining term, which is the same discounting arithmetic run in reverse.
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