Treasury Strips

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Treasury Strips?

Treasury strips are fixed income products similar to bonds but sold at a discount and mature at face value, much like zero coupon bonds with the difference that they are backed by the government and hence are virtually free from credit risk.

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These are high-quality debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more as they provide credit-free interest and have sovereign backing. They enable the investors to enjoy the earnings of treasury bills and bonds with a much lower investment. They are used by portfolio managers to hedge the risks and for asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals.read more, thereby helping generate returns even in volatile markets.

Key Takeaways

  • Treasury STRIPS are fixed-income securities that are sold at a discount and mature at their face value, resembling zero-coupon bonds. However, a key distinction lies in their government backing, rendering them virtually free of credit risk.
  • These financial instruments originate from Treasury and Sovereign bonds, representing a method of separating the interest and principal components.
  • Backed by the government, STRIPS provide investors the opportunity to reap the benefits of Treasury bills and bonds through a relatively lower investment. These instruments serve portfolio managers as tools to hedge risks, allocate assets, and potentially generate profits even within volatile market conditions.

Treasury Strips Explained

STRIPS is an acronym that stands for Separate Trading of Registered Interest and Principal of securities. These are specific financial products that are carved out of treasury/Sovereign bonds. In simple terms, this is nothing but stripping of the expected cash flow of a bond into multiple individual fixed-income products.

Treasury strips are used not only for investments but also by economists, investors, and regulators to measure the zero-coupon Treasury yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more. Because of the fungibility these treasury strips data provide, these are unaffected by a single underlying security and give a smooth yield curve without any discontinuity. The finance community uses these financial products to extrapolate the curve behavior and forecast the interest rate curves, economic health, and the direction it moves. Two primary methods to calculate this curve are – Nelson-Siegel and Fisher – Nychka Zervos, named after the mathematicians who empirically calculated these.

The market for treasury strips data has grown into a huge one due to its stability and ease of investment. As per market figures in 1999, of all bonds, 37% of these were held in STRIPS and could be valued at $ 225 billion. Since these can be repackaged and demand-supply can be created, there are sizeable flows even in times of distress like the 2000 dot com bubble burst and the great depression of 2008.

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Examples

Let us understand the concept with the help of an example.

Let us take an example of a fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more product with a time to maturity of 10 years. The coupon payment is made annually at a coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more of 8%. Going by the contract terms of this bond, there will be 11 coupon payments in total. These payments can be repackaged into 11 zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more and could be called STRIPS in the financial community. Since the U.S. government distributes these, they are called treasury strips and have the comfort of being reliable and creditworthy.

Treasury-Strips

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Lest consider the cash flow of the simple vanilla bond

Treasury Strips Example 1

Now let’s consider the cash flow when this bond is stripped into multiple strips (treasury strips in the case of sovereign bonds). The new cash flow will be as follows: each coupon payment has become the treasury strips maturity date for the new zero-coupon bonds stripped from the original Vanilla bond.

Bond NameFVMonth
Bond 1$40001-Jan-18
Bond 2$40001-Jan-19
Bond 3$40001-Jan-20
Bond 4$40001-Jan-21
Bond 5$40001-Jan-22
Bond 6$40001-Jan-23
Bond 7$40001-Jan-24
Bond 8$40001-Jan-25
Bond 9$40001-Jan-26
Bond 10$40001-Jan-27
Bond 11$5,00001-Jan-27

Calculations on the treasury strip’s return on investment (ROI) are a bit compelled. There can be 2 cases.

1) If the treasury strip is liquidated before the maturity date, then

Return Calculated = Current Market Value – Purchased Price

2) The second scenario is when they are held until the treasury strips maturity date. Then

Return Calculated = Face Value of the Bond – Purchase Price

Advantages

Some of the advantages of this financial instrument is elaborated below:

Risks

STRIPS have inherent risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more because of their unique characteristics. Let’s consider these in detail.

  1. Credit Risk – Since the US government backs these, they are considered safe and have credibility similar to sovereign bonds. Hence, they are considered free from any default and have no credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more.
  2. Interest Rate Risk – Since these financial instruments do not pay interests on a periodic basis, they are able to eliminate the reinvestment risks, which is the risk of reinvesting the coupons at a lower interest rate.
  3. Liquidity Risk – Compared to Treasury bonds, Treasury STRIPS are less liquid. This may lead investors to pay more in commissions to the brokers. Also, because of the less liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, there is a difference in bid and ask treasury strips prices, which may lead to 2 major problems- it will be challenging to get in and out at desired treasury strips prices and to affect the hedge for which these STRIPS were initially bought. Second, it may lead to a liquidity crisis because the high difference in bid-ask price liquidity may fluctuate further. Participants might find it challenging to get their orders through. However, STRIPS develop a unique mechanism due to their distinct characteristics. A broker can strip or repackage it flexibly to create new demand/supply through restriping at new equilibrium levels.

Treasury Strips Vs Zero-Coupon Bonds

The above are two different investment instruments that do not give interests to investors periodically like traditional bonds. However, let us point out some differences between them.

  • The former is created by removing the interest component and principle form the US treasury bonds or notes but the latter is issued in the form of no coupon payments.
  • The former represents individual cash flows from a particular treasury bond, where each strip is against a payment or maturity date. But the latter is a standalone bond with a single maturity date and no interest payment.
  • The issuer or the former is the US Department of Treasury whereas the latter can be issued from the government, financial institution or municipality.
  • The zero-coupon bonds are less commonly traded in the secondary market as compared to treasury strips.
  • Both have different tax treatment. The treasury strips taxation is subject to annual tax treatment based in imputed interest, even though there is no actual interest payment. The latter may be subject to taxation on accretion of interest over time or on maturity unlike the treasury strips taxation.

Thus the above are some of the essential points of differences between them.

Frequently Asked Questions (FAQs)

1. Are treasury STRIPS a good investment? 

Treasury STRIPS can be appealing for certain investors seeking predictable income and principal payments. The U.S. government backs them and offers protection against default risk. However, due to their zero-coupon nature, they don’t provide regular interest income, making them more suitable for those with long-term investment horizons.

2. What is the risk in treasury STRIPS? 

The main risk with Treasury STRIPS is interest rate risk. Since they don’t pay interest until maturity, changes in interest rates can impact their market value. If rates rise, the value of existing STRIPS may decline. Additionally, while default risk is low due to government backing, inflation risk could erode the purchasing power of the fixed future payment.

3. What are the treasury STRIPS and TIPS? 

Treasury STRIPS are securities created by separating the interest and principal components of Treasury bonds, resulting in zero-coupon bonds. They offer a known future payment upon maturity. On the other hand, Treasury Inflation-Protected Securities (TIPS) protect against inflation by adjusting the principal value with changes in the Consumer Price Index. TIPS offers a fixed interest payment along with an inflation-adjusted principal. The U.S. Department of the Treasury issues both.

Recommended Articles

This has been a guide to what are Treasury Strips. We explain them with example, differences with zero-coupon bonds, risks and advantages. You can learn more about it from the following articles –

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