What are Treasury STRIPS?
Treasury STRIPS are zero-coupon bonds sold for less than par and pay no interest because the cash flow component was carved out to be separately traded in the secondary markets.
Treasury STRIPS Government Bond Features
STRIPS are created from the separation of sale of individual parts of government-issued securities, namely Treasury bonds.
STRIPS stands for “Separate Trading of Registered Interest and Principal of Securities,” a government program where investors can own parts of eligible Treasury issuances (e.g. notes, bonds).
The components of Treasury notes and bonds – the principal and interest of the securities – are separated into distinct holdings, in what is referred to as “coupon stripping.”
- Principal: The face value (FV) of the bond, i.e. the amount due at maturity.
- Interest: The periodic interest expense payments due before maturity.
Each component can be purchased and sold as individual securities on the secondary markets upon separation.
Therefore, STRIPS are bonds in which the coupon (interest) component was removed to be sold separately, so the only source of income stems from the payment made at maturity.
Treasury STRIPS Price and Yield
Since no interest is paid throughout the borrowing term, STRIPS are sold below par, making them a zero-coupon bond.
- Treasury STRIPS are sold at a discount to par, i.e. the face value.
- No coupons (interest payments) are paid to the owners of STRIPS throughout the borrowing period.
- The full face value (FV) of the STRIP is repaid at maturity.
- Brokers and dealers actually facilitate the purchase of “Treasury” STRIPS rather than the Federal Reserve (or central government).
- The difference between the purchase price and the par value is the return earned by the investor.
Are Treasury STRIPS Government-Backed?
Despite a common misconception, the U.S. government (i.e. Federal Reserve) is not the direct issuer of Treasury STRIPS.
Rather, STRIPS are securities created by financial institutions (e.g. brokerage firms, investment banks) using conventional government securities.
Nevertheless, STRIPS are still considered to be backed by the “full faith and credit” of the U.S. government (i.e. no default risk in theory) despite not being issued by the government itself.
The investors of STRIPS are most often long-term institutional investors that prioritize guaranteed stable income at maturity, i.e. STRIPS make a fixed, one-time payment to investors on the date of maturity.
Taxes on Treasury STRIPS
However, interest is NOT paid on STRIPS, so these represent discount issuances that mature at their par value, i.e. the concept of an original issue discount (OID).
Nevertheless, the so-called “phantom income” (the income equal to the rise in the bond value over time) must be reported for tax purposes.
Irrespective of the fact that the investor has not technically received a “gain” yet (i.e. the bond was not sold, or not reached maturity), the income is still reported as if it was received.
If the STRIPS are sold before maturity, the accrued OID interest may be taxable on the date of sale.
The underlying government bond could also be a Treasury inflation-protected security (TIPS) or municipal bond, so professional advisory from an accountant is recommended to help investors understand the complexities around the taxation of STRIPS.