What are Treasury Strips?
Treasury strips are fixed income products similar to bonds but sold at a discount and mature at face value, very much like zero coupon bonds with a difference that they are backed by government and hence are virtually free from credit risk.
Examples
- 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.
- Let us take an example of a fixed income product with a time to maturity of 10 years. The coupon payment is done on an annual basis at a coupon rate 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 bonds and could be called STRIPS among the financial community and since these are distributed by the U.S. government, they are called treasury strips and have the comfort pf being reliable and creditworthy.
Lest consider the cash flow of the simple vanilla bond
Now let’s consider the cashflow when this bond is stripped into multiple strips (treasury strips in case of sovereign bonds). The new cash flow will be as follows where each coupon payment has become the maturity date for the new zero-coupon bonds stripped from the original Vanilla bond.
Calculations for return on investment (ROI) on treasury strip is a bit compels. There can be 2 cases
1) If the treasury strip is liquidated before the maturity date, then
2) The second scenario is when the treasury strip is held until the maturity date. Then
Advantages of Treasury Strips
- Have a huge range of maturities: As explained above treasury strips are carved out of Vanilla bonds. Hence, they are customized by dealers as per the demand and can have a varying range of maturities.
- These are similar to zero-coupon bonds as they are issued at a fair discount and are matured at face value as explained in the above example
- The cash flow is quite simple and direct as there are no interest payments and face value are received at maturity.
- This can be invested in even in small chunks and hence is quite favorite among retail investors too.
- One of the best advantages of this financial product is that they are backed by the government and hold the same credibility as Sovereign bonds.
- Owing to the customization they provide; these strips are the best mechanism for hedging.
Important Points
STRIPS have inherent risks because of their unique characteristics. Let’s consider these in detail.
- Credit Risk – Since these are backed by the US government, they are considered safe and have credibility similar to sovereign bonds. Hence, they are considered to be free from any type of default and have no credit risk.
- Interest Rate Risk
- 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 liquidity, there is the difference in bid and ask prices which may lead to 2 major problems- it will be difficult to get in and out at desired prices and affecting the hedge for which these STRIPS were initially bought and second it may lead to a liquidity crisis as because of high difference in bid-ask price liquidity may fluctuate further and participants might find it difficult to get their order through. However, STRIPS come up with a unique mechanism owing to their distinct characteristics where a broker can strip or repackage it in a flexible manner to create new demand/supply through restriping at new equilibrium levels.
- The market for treasury strips has grown into a huge one due to the stability and ease of investment that it provides. 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 2000 dot com bubble burst and the great depression of 2008.
- Treasury strips are used not only for investments but also by economists, investors, and regulators to measure the zero-coupon Treasury yield curve. The finance community uses these financial products to extrapolate the curve behavior and forecast the interest rate curves and the economic health and the direction in which it is moving. Because of the fungibility that these strips provide, these are not affected by a single underlying security and hence provide a smooth yield curve without any discontinuity. Two major methods to calculate this curve are – Nelson-Siegel and Fisher – Nychka Zervos named after the mathematicians who empirically calculated these.
Conclusion
These are very high-quality debt instruments as they provide a credit free interest as they have sovereign backing. They enable the investors to enjoy the earnings of treasury bills and treasury bonds with a much lower investment. They are used by portfolio managers to hedge the risks and for asset allocation thereby helping generate returns even in volatile markets.
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