Return to:Previous Page
Morningstar.com's Interactive Classroom

Course 206
STRIPS

Introduction

STRIPS are relative newcomers to the investment scene. They are a twist on Treasury notes and bonds, and they represent a way to buy these securities indirectly. The investor in Treasury securities can find a number of advantages to investing with STRIPS. This course will introduce you to these securities and the potential reasons for buying them.

What Are STRIPS?

Let's start with a few definitions. STRIPS (Separate Trading of Registered Interest and Principal of Securities) are debt securities that are created through the process of coupon stripping. They are essentially traditional Treasury bonds, except that the bond's principal (its corpus) has been separated--stripped--from its interest (its coupon). Investors may then choose to purchase securities based on either the principal or interest of the bond.

STRIPS take the form of zero-coupon securities. That is, they make no periodic interest payments, as most bonds do. Instead, you buy them at a deep discount from their face value, which is the amount you receive when they mature. This means that investors know exactly how much they will earn from their STRIPS investments. This, along with the high security of the bonds that back them, make STRIPS popular with some investors.

Before 1986, a number of brokerage firms created their own zero-coupon securities by stripping the coupons from Treasury bills and bonds they purchased and held in escrow. They went by a number of feline acronyms: CATS, TIGRs, LIONs, etc. Then the Treasury introduced the STRIPS system, in which brokerages create zero coupons based on book-entry receipts for Treasury instruments. While STRIPS are based on underlying Treasury instruments, they are sold by brokerage firms.

How Do STRIPS Work?

STRIPS are zero-coupon securities issued by brokerage firms and based on receipts for Treasury securities. Any Treasury issue with a maturity of 10 years or longer is eligible for the STRIPS process.

Here is how the process works. Brokerage firms purchase Treasury securities through the means of book-entry receipts; that is, the Treasury records the firm's ownership of the bonds or notes, but the firm does not actually hold certificates that later need to be redeemed. Based on its receipts, the firm then strips the principal from the interest and creates zero-coupon securities based on portions, or units, of the principal or interest of the security.

For example, let's imagine a 20-year bond with a face value of $20,000 and a 10% interest rate. A brokerage could purchase a receipt for the bond and strip the principal from its 40 semiannual interest payments. It would then sell to investors 41 separate zero-coupon securities, each with different maturities based on when the interest payments on the Treasury bond were due. The zeros would be discounted to the present value using the prevailing interest rate and term to maturity. If the principal unit of $20,000 was discounted by 10% for 20 years, it would sell for $2,973 (ignoring any markup or commissions). Upon maturity, the principal would be worth $20,000, and each of the interest-backed securities would pay $1,000 (one half the annual interest on the bond). The brokerage would use its earnings from its Treasury bond to pay the holders of the STRIPS as they mature.

Of course, as with other debt securities, investors do not have to hold the STRIPS to maturity to cash in. An active secondary market exists, on which individual STRIPS may be traded at market value until maturity.

Why Are STRIPS Popular?

There are a number of reasons why STRIPS are popular with investors. To begin with, the fact that STRIPS are backed by U.S. Treasury securities makes them very high-quality debt instruments. Even the slight default risk that was possible with privately issued zeros in the 1980s was removed with the book-entry STRIPS system.

Second, STRIPS allow investors to take advantage of the earnings of Treasury bills and bonds without a large outlay of capital. While it takes a minimum investment of $10,000 to purchase Treasury bonds, for instance, a STRIP based on the interest of the T-bond may cost only a few hundred dollars.

The fact that STRIPS are zero-coupon securities means that you know in advance what the future value of your investment will be. The STRIP will always pay its face value at maturity, and your return will be the difference between the face value and the discounted price you paid for it. By contrast, if a standard bond issue is called, the investor loses the amount of interest the bond would have paid until maturity. The predictable returns of STRIPS can be beneficial in planning for specific goals.

Another advantage of STRIPS over the Treasury securities they are based on is the variety of maturity dates available. Since STRIPS can be based on interest payments, there is no need to wait decades for maturity, and you can choose from a range of maturity dates that will offer differing returns. The returns on STRIPS also represent an automatic reinvestment of interest. There is no reinvestment risk--the risk that the cash flow produced by an investment would have to be reinvested at a lower rate of return.

There is an active secondary market for STRIPS, where their prices can be quite volatile based on returns, maturity, and changes in general interest rates. Also, STRIPS are eligible for inclusion in tax-deferred retirement plans, in which their value would grow tax-free until your retirement.

STRIPS Meet the Demand for Zero Coupon Debts

Now let's review what you have learned.

STRIPS are zero-coupon securities based on U.S. Treasury bills and bonds. Brokerage firms strip the bonds' interest from their principal and issue separate securities based on units of principal or interest. STRIPS permit investors to take advantage of the performance of high-quality Treasury instruments without the risk of bonds being called, and at a much lower cost than purchasing Treasury bills and bonds.

See the other courses on bonds in the Investing Classroom for more types of coupon-stripped securities.

Quiz 206
There is only one correct answer to each question.

1 Coupon stripping means separating a bond's _______ from its _______.
a. Face value/corpus
b. Interest/coupon
c. Interest/principal
2 XYZ Brokers, Inc. issues STRIPS based on the semiannual interest payments of a 10-year Treasury bond. How many different maturity dates will the STRIPS have?
a. 1
b. 10
c. 20
3 Which U.S. Treasury securities are eligible for STRIPS?
a. All of them
b. Those with maturities longer than 10 years
c. Those with maturities longer than 20 years
4 Which is not a benefit of STRIPS?
a. Federal tax-free returns
b. Safety
c. Predictable returns
5 Who sells STRIPS?
a. The U.S. Treasury
b. Corporations
c. Brokerage firms
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
Return to:Previous Page