What it means
An ordinary Treasury bond pays interest every six months and returns the principal at maturity. Through the STRIPS programme, financial institutions can split each of those payments into a separate security, so a 10-year bond becomes 20 interest pieces plus one principal piece.
Each piece then trades on its own, with its own price and yield. Each strip has a face value and a maturity date, pays no interest in between and is bought at a price below face value.
The investor's return is the difference between the purchase price and the payment at maturity. The securities are held through the book-entry system of the central bank and financial institutions, and they are traded through brokers and dealers.
They are not usually bought directly by individuals through the government's retail website, so most investors reach them via a brokerage account. Investors use STRIPS to match a known future liability.
A business that needs $250,000 in seven years for a building payment can buy strips maturing then, without worrying about reinvestment risk (the risk that interest received along the way must be reinvested at lower rates). The main drawbacks are price volatility and tax.
Because there are no coupon payments to cushion falls, long-dated strips swing widely when yields change, and in many places the yearly accrual of discount is taxable even though no cash is received. Pension funds and insurers are heavy users, since they have long-dated liabilities.
They like that the maturity can be chosen to fall exactly when a payment is due. Individual investors often hold them in tax-advantaged accounts to avoid paying tax on income they have not received in cash.
In practice
Real-world examples.
Example
A university foundation needs $5,000,000 in 12 years to fund a new building. It buys strips maturing in that year, knowing the amount will be there regardless of market moves. The trustees record the strips at cost plus accrued discount in their annual report.
Example
A retiree builds a ladder of strips maturing in each of the next five years. Each one pays out as it matures, and the amounts are chosen to cover living costs.
Example
A bond trader expects interest rates to fall and buys long-dated strips because their prices rise more than those of ordinary bonds when yields drop. The position also loses more if rates rise, so she sets a limit on how much she can lose. Her risk manager reviews the position every day.
Formula
Calculation
The approximate annual yield on a strip is:
Yield = (Face value / Price) ^ (1 / Years) - 1
An illustrative strip has a face value of $100,000, matures in 10 years and costs $70,000. The total gain is $100,000 - $70,000 = $30,000. The yield is ($100,000 / $70,000) ^ 0.1 - 1 = 1.4286 ^ 0.1 - 1, which is about 3.63% a year. In the first year the accrued, taxable discount is roughly $70,000 x 0.0363 = $2,541, even though the investor receives no cash until maturity.Case study
Seen in the real world.
Oakhaven Insurance is an illustrative, fictional insurer that had agreed to pay a lump sum of $8,000,000 on a long-term policy in 15 years. The investment team wanted to remove the risk that its assets might not be worth enough on the payment date.
They bought strips maturing in that year, spending about $4,700,000 at the prevailing yield. As interest rates rose in the next two years, the market value of the strips fell, and a board member asked why the company held an investment that had lost value.
The chief investment officer pointed out that the liability had fallen in present value by a similar amount, so the net position was stable. In this illustrative case the strips matured on the due date and provided exactly the amount needed, which showed why matching assets and liabilities matters more than short-term price swings. The board later adopted a policy of reviewing the matching position once a year instead of reacting to monthly valuations.
Watch out
Common mistakes.
- Expecting income from strips, when they pay nothing until maturity.
- Ignoring tax on the accruing discount, which can create a bill without any cash coming in. Holding strips in a tax-advantaged account can avoid this problem.
- Buying long-dated strips as a safe short-term holding, when their prices can fall sharply.
Questions
People also ask.
Are STRIPS backed by the government?
The underlying payments are obligations of the US Treasury, so credit risk is very low, but market prices still move with interest rates.
Why are the prices so different from face value?
Because the investor receives nothing until maturity, so the price is the future payment discounted at the market yield.
Who creates them?
Financial institutions separate eligible Treasury securities into their parts through the government's book-entry system. The Treasury does not sell them directly to the public.
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