STRIPS & Receipts

You don’t need to know this for the exam, but STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. That’s a fancy way of saying STRIPS are long-term, zero coupon bonds issued by the US Government. They are issued at deep discounts, then mature at par several years later.

STRIPS, as well as any zero coupon bond, are not suitable for investors seeking income. Normally, an investor could purchase a set of bonds and live off the semi-annual income. This won’t occur with STRIPS, which only pay interest at maturity (which could be up to 30 years later).

Assume you find 20-year STRIPS selling for $600. You purchase the STRIPS today for $600, hold the investment for 20 years, then receive $1,000 at maturity. Your return over 20 years would be $400, or the equivalent of $20 a year in interest.

There’s another security that’s very similar to STRIPS, but they’re not securities of the US government. Treasury Receipts are created by financial institutions like banks and investment firms. Just like STRIPS, Treasury Receipts are long-term, zero coupon bonds. To create Treasury Receipts, financial institutions purchase sets of Treasury Notes and Treasury Bonds, place them into a portfolio, strip them of their coupons, and re-sell them as zero coupon bonds.

You won’t need to know the logistics of creating a Treasury Receipt. It’s most important to know they’re very similar to STRIPS, but have slightly different backing. Treasury Receipts are created without government oversight (in particular, Federal Reserve oversight), which means they do not have the direct backing of the US Government. While the securities used to create Treasury Receipts (T-notes and T-bonds) are fully backed, the new product created with the manipulated Treasury securities is not backed. STRIPS are not technically issued by the US Government (securities dealers issue them), but the Federal Reserve oversees their creation, which gives them the same backing as other Treasury securities like Treasury bills, notes, and bonds.

If the previous paragraph was confusing, it’s because the system in place is confusing. The big point to remember is STRIPS are fully backed by the US Government, while Treasury Receipts are not. Of course, this could factor into safety and yield. STRIPS are slightly safer and trade with lower yields, while Treasury Receipts are slightly riskier and trade with higher yields.

Both STRIPS and Treasury Receipts are subject to annual taxation, even though investors won’t receive interest until maturity. This is sometimes referred to as “phantom tax.” If you purchase 20-year STRIPS at $600, you’ll receive a tax bill for $20 of interest annually ($400 discount / 20 years = $20 annualized interest). The IRS prefers to get their tax money sooner rather than later!

We first discussed price volatility in the bond fundamentals chapter. If you recall, the market price of bonds with long maturities and low coupons move the fastest when interest rates change. STRIPS and Treasury Receipts have very volatile market price movements because they meet both characteristics: long-term (up to 30 years) and low coupon (0%). Investors should be aware of the potential price volatility prior to investing in these types of securities.

To be clear, even though STRIPS and Treasury Receipts have a 0% interest rate, they are very subject to interest rate risk. A bond does not need to pay ongoing interest to be subject to interest rate risk.