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. In plain terms, STRIPS are long-term, zero coupon Treasury securities. They’re sold at a deep discount and then mature at par value years later.

STRIPS (and any zero coupon bond) aren’t suitable for investors who want current income. With most coupon bonds, you can buy a portfolio of bonds and use the semiannual interest payments as income. STRIPS don’t work that way because they don’t make periodic interest payments. Instead, all the interest is effectively paid at maturity (which could be up to 30 years later).

Assume you find 20-year STRIPS selling for $600. You buy the STRIPS today for $600, hold the investment for 20 years, and then receive $1,000 at maturity. Your total return over 20 years is $400, which is the equivalent of $20 per year in interest.

There’s another product that’s very similar to STRIPS, but it isn’t backed in the same way. Treasury Receipts are created by financial institutions like banks and investment firms. Like STRIPS, Treasury Receipts are long-term, zero coupon bonds. To create Treasury Receipts, financial institutions buy Treasury Notes and Treasury Bonds, place them into a portfolio, strip them of their coupons, and then re-sell the pieces as zero coupon bonds.

You won’t need to know the step-by-step logistics of creating a Treasury Receipt. The key point is that Treasury Receipts look a lot like STRIPS, but the backing is slightly different. Treasury Receipts are created without government oversight (in particular, Federal Reserve oversight), so they don’t have the direct backing of the US Government. The underlying securities used to create Treasury Receipts (T-notes and T-bonds) are fully backed, but the new product created from those securities is not backed in the same direct way. STRIPS aren’t 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 that distinction feels confusing, it’s because the system is confusing. The main point to remember is that STRIPS are fully backed by the US Government, while Treasury Receipts are not. This can affect both safety and yield: STRIPS are slightly safer and tend to trade at lower yields, while Treasury Receipts are slightly riskier and tend to trade at higher yields.

Both STRIPS and Treasury Receipts are subject to annual taxation, even though investors won’t receive cash interest until maturity. This is sometimes called phantom tax. For example, if you buy 20-year STRIPS at $600 and receive $1,000 at maturity, the $400 discount is treated as interest earned over time. That works out to $20 of interest per year ($400 discount / 20 years = $20 annualized interest), and you’ll owe taxes on that amount each year.

We first discussed price volatility in the bond fundamentals chapter. Remember: bonds with long maturities and low coupons tend to move the most when interest rates change. STRIPS and Treasury Receipts are especially volatile because they have both characteristics: long-term maturities (up to 30 years) and a 0% coupon. Before investing, you’ll want to understand how sharply their market prices can rise or fall as rates change.

To be clear, even though STRIPS and Treasury Receipts have a 0% coupon, they’re still highly exposed to interest rate risk. A bond doesn’t need to pay ongoing interest to be sensitive to changes in interest rates.