Definition / Meaning
Treasury strips are stripping of a bond’s expected cash flow into individual bonds. Assume there is a 5-year bond having a face value of $10,000 bond that pays 6% coupons paid annually. There are a total of 6 coupon payments, including 5 interest payments and 1 face value payment. Each of these payments is stripped/converted into 7 zero-coupon bonds. Each such bond is called strips, and since the U.S. government issues these, they are called treasury strips.
In Treasury Strips, the word STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. The literal meaning of stripping applies here, i.e., it strips a bond into several bonds, each having a separate par value. This process of stripping is called coupon stripping.
When the U.S. citizens used to invest in TIGR by Merrill Lynch and CATS by the U.S. government, treasury strips came into the picture, and the former became obsolete.
Take the same example as given in the definition. The table below shows that the bond is stripped into various bonds with different FV and Maturity Dates. The face value is equal to the coupon value, and the maturity date is the same as the coupon payment date.
Maturity = 5-year from 1st of Jan 2017
Face Value = $1,000
Coupon Rate = 6% paid annually
The calculation of return on TREASURY STRIPS becomes quite simple, like stock trading. The formula for the calculation can be as simple as follows:
If the bond is sold before maturity,
Return = Trading Value – Purchase Price.
If the bond is held till maturity,
Return = Face Value – Purchase Price.
Treasury Strips Characteristics
Following are the characteristics of treasury bonds.
- It is a type of zero-coupon bond categorized under fixed income securities.
- It matures at face value and is issued at a significant discount.
- There are no interest payments.
- Pay-out known in advance with a maturity date
- Need to pay federal income tax on bond’s accretion whether received in cash or not.
- It can be purchased from financial institutions, brokers, etc. but not directly from the treasury.
- They are considered safe because the government backs them.
- Easy to invest as there is a smaller chunk of money invested.
- Minimum 10-year bonds are eligible for stripping.
Learn more about various other types of bonds at Bonds and their Types.