What Are Treasury STRIPS? – Investment Guide
STRIPS, which stands for Separate Trading of Registered Interest and Principal of Securities, are securities that consists of a U.S. Treasury bond that has been stripped of its interest coupons. Investors buy STRIPS at a steep discount from face value and can redeem them for full face value at maturity. STRIPs are very low-risk investments for income investors, who often use them to fund retirement in tax-deferred accounts. A financial advisor can help you find just the right highly liquid and secure fixed-income securities for your portfolio.
STRIPS Background
Treasury bonds pay interest semi-annually and each interest payment is referred to as a coupon. So, a 10-year Treasury bond will have 20 coupons. In the 1970s, financial firms began removing or stripping the paper coupons from bond certificates and trading the resulting securities separately. A 10-year stripped Treasury could produce 21 securities consisting of the original bond and the 20 interest coupons. The resulting STRIPS and coupons can be bought and sold at market prices.
When stripping of Treasury bonds began, the government discouraged the practice due to concerns about lost tax revenues. However, in 1982 tax laws were modified to change tax treatment of zero-coupon bonds. The Treasury department then accepted stripping and also began issuing bonds electronically, without paper certificates or coupons.
STRIPS Defined
In 1985, the government introduced the STRIPS program. Any Treasury bond with a 10-year maturity or longer is eligible to be stripped with the Treasury’s approval. However, the government does not issue STRIPS. Private-sector financial services firms perform the stripping process and investors buy the stripped securities from them.
STRIPS are a kind of zero-coupon bond. Other types of bonds, including corporate and municipal bonds, may also be stripped of their interest coupons and traded as zero-coupon bonds. But only stripped Treasury bonds are called STRIPS.
Just as Treasury bonds can be stripped of their coupons to make STRIPS, the coupons can be re-attached to the bonds. These reconstituted STRIPS are sometimes used when the Treasury engages in buyback programs.
Taxes and STRIPS
Although STRIPS investors don’t receive any interest payments, for income tax purposes investors have to report the interest as if they had received it. They report it on their returns for the year it was earned. The broker or financial institution that oversees the STRIPS account sends each investor an annual report on income earned. Because of the requirement to pay taxes on income that hasn’t actually been received, STRIPS are mostly used in tax-deferred retirement accounts such as IRAs and 401(k) plans.
Investing With STRIPS
A STRIP begins with a Treasury bond that is stripped of its coupons and sold at a discount. For instance, a 30-year Treasury bond paying a coupon interest rate of 2% may sell for $200 or less. Then, when the bond matures in 30 years, the holder can cash it in for the full $10,000.
Since the Treasury does not sell STRIPS, investors must purchase STRIPS from brokers or other financial institutions. However, investors can buy STRIPS from many private-sector brokers and other sellers. The minimum investment is $100.
STRIPS have several attractive features for investors, including:
No risk of default because of the backing of the U.S. government
No risk of the bond being called before maturity
Ability to invest with small sums due to the steep discount on face value
Certainty about future value of the investment at maturity
Investors use STRIPS to fund retirement, higher education and other long-term financial goals. Because STRIPS are sold at a steep discount to face value, an investor can start with a relatively small sum.
STRIPS are also widely available and are actively traded in a secondary market. Because of this secondary market, STRIPS investors don’t have to wait for the bonds to mature to cash in. They can sell the bonds for the going rate at any time. However, investors can choose from STRIPS with a variety of maturity dates. So they can often purchase STRIPS that will have maturity dates that suit their financial goals.
Although the default risk on STRIPS is negligible, they do carry some risks. The main one is that if interest rates fall the STRIPS will be less valuable on the secondary market. So an investor could generate less return than expected if for some reason he or she must sell the STRIPS before maturity.
Bottom Line
STRIPS are low-risk, high-liquidity investments backed by the U.S. Treasury. They are created when private-sector brokers and other financial institutions remove the interest coupons from Treasury bonds of 10 years maturity or longer, then sell the stripped bonds at a steep discount to face value. Investors get their return by cashing in the bonds for full face value when they reach maturity. Or they can sell the STRIPS in the secondary market. STRIPS are popular investments for long-term goals such as retirement and college savings.
Tips on Investing
STRIPS can help investors reach financial goals. But are they the best fit for your financial goals, risk profile and timeline? An experienced and qualified financial advisor can give you an objective, third-party assessment of your choices. Finding such an advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
Bond investors must be acutely aware of the risk inflation poses to their investments. Use this free inflation calculator to see what your money will be worth over a set period of time and at a designated inflation rate.
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