What are Treasury STRIPS and how are they created from regular Treasury bonds?

Question

AcadiFi · Accepted Answer

STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon securities created by separating a Treasury bond's coupon payments and principal payment into individual tradeable securities.

```mermaid
graph TD
    A["Treasury Bond
5% Coupon, 3-Year
Face = $1,000"] --> B["Strip Process
(by Primary Dealer)"]
    B --> C["Coupon STRIP #1
$25 in 6 months"]
    B --> D["Coupon STRIP #2
$25 in 12 months"]
    B --> E["Coupon STRIP #3
$25 in 18 months"]
    B --> F["Coupon STRIP #4
$25 in 24 months"]
    B --> G["Coupon STRIP #5
$25 in 30 months"]
    B --> H["Coupon STRIP #6
$25 in 36 months"]
    B --> I["Principal STRIP
$1,000 in 36 months"]
    style A fill:#c9a84c,color:#000
    style I fill:#3b82f6,color:#fff
```

**The Stripping Process:**

1. A primary dealer buys a regular Treasury bond (e.g., $1M face, 5% coupon, 3-year maturity)
2. The dealer asks the Treasury to 'strip' the bond into its component cash flows
3. Each semiannual coupon becomes a separate zero-coupon security
4. The principal at maturity becomes a separate zero-coupon security
5. Each STRIP trades independently in the secondary market

**Example — 3-Year 5% Treasury, $100,000 Face:**

| STRIP | Cash Flow | Maturity | Current Price (at 4% yield) |
|---|---|---|---|
| C-STRIP 1 | $2,500 | 6 months | $2,451 |
| C-STRIP 2 | $2,500 | 12 months | $2,404 |
| C-STRIP 3 | $2,500 | 18 months | $2,357 |
| C-STRIP 4 | $2,500 | 24 months | $2,312 |
| C-STRIP 5 | $2,500 | 30 months | $2,268 |
| C-STRIP 6 | $2,500 | 36 months | $2,224 |
| P-STRIP | $100,000 | 36 months | $88,900 |
| **Total** | | | **$102,916** |

**Why Investors Prefer STRIPS:**

1. **Zero reinvestment risk:** No coupons to reinvest, so your holding period return is locked in
2. **Duration matching:** Perfect for immunizing a specific future liability (pension payment, insurance claim)
3. **Tax treatment:** In taxable accounts, imputed interest (phantom income) is taxable annually even though no cash is received — but in tax-deferred accounts, this is not an issue
4. **Volatility:** Higher duration per dollar invested than coupon bonds, so more price sensitivity for speculative positions

**Exam Tip:** STRIPS eliminate reinvestment risk but have higher interest rate risk (longer duration) than coupon bonds of the same maturity. Know the tax implication of phantom income.

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What are Treasury STRIPS and how are they created from regular Treasury bonds?

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Practice Questions

STRIP	Cash Flow	Maturity	Current Price (at 4% yield)
C-STRIP 1	$2,500	6 months	$2,451
C-STRIP 2	$2,500	12 months	$2,404
C-STRIP 3	$2,500	18 months	$2,357
C-STRIP 4	$2,500	24 months	$2,312
C-STRIP 5	$2,500	30 months	$2,268
C-STRIP 6	$2,500	36 months	$2,224
P-STRIP	$100,000	36 months	$88,900
Total			$102,916