background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024
:
Private EquityReal Estate Investing
Hedge Fund InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open
Wall Street Prep

Treasury STRIPS

Step-by-Step Guide to Understanding Treasury STRIPS

Last Updated February 20, 2024

Learn Online Now

Treasury STRIPS

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.

The Wharton Online
& Wall Street Prep
Buy-Side Investing Certificate Program

Fast track your career as a hedge fund or equity research professional. Enrollment is open for the Sep. 9 - Nov. 10 cohort.

Enroll Today

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

If interest is earned on Treasury STRIPS, the income is taxed in the period received (i.e. realized profits), as with most equity (e.g. dividends) and debt investments (e.g. corporate bonds).

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.

STRIPS are often found in tax-deferred accounts, such as retirement accounts (IRA) and 401(k) plans in addition to exchange-traded funds (ETFs) and mutual funds.

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.

Comments
0 Comments
Inline Feedbacks
View all comments

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.