Updated June 21, 2023
Definition of Treasury Strips
Treasury strips are Zero-Coupon Bonds issued by the US government and are essentially risk-free as a guarantee that the US government backs them. The type of fixed-income securities are issued as deep discounts and are paid at par value on the maturity of such instruments.
The term STRIPS in the name Treasury Strips stands for Separate Trading of Registered Interest and Principal of Securities. Treasury Strips are low-risk instruments.
Explanation
In simple words, Treasury strips involve stripping the different cash flows of a fixed coupon-bearing bond, thereby making it different from zero-coupon bonds. Since the US government backs these, these are popularly known as Treasury strips.
Usually, the period required for fixed-income bonds to be eligible for stripping varies; however, the normal minimum maturity period is ten years to strip. Treasury Strips are quoted normally on a yield basis and are sometimes known as Synthetic Zero-Coupon Bonds in common parlance.
Purpose of Treasury Strips
Treasury Strips are issued for various purposes, and the objective differs for the issuer and investor. Some well-known purposes for issuing Treasury Strips are:
- First, it involves lower investment as these are deep discount instruments.
- It eliminates reinvestment risk as there are no intermittent cash flows, and payment inflow is known in advance.
- Offers fungibility, which means coupon strips from different bonds are exchangeable.
It also offers amazing arbitrage opportunities when the strips are generated from the coupon-bearing stock, and the sum of the prices of strips differ. This is one of the purposes and provides an opportunity to benefit by going long or short, as the case may be, and benefit from the price imbalance.
Example of Treasury Strips
Let’s understand the Treasury strip with the help of an example:
Suppose a Financial Institution has purchased a ten-year bond with semi-annual coupon payments of 6%. The face value of the 10-year bond is $10000.
The financial institution can repackage the 10-year bond cash flows comprising 20 coupon-only interest inflows and one principal-only cash inflow into different strips and sell the same as separate Strips. The strips will be paid back on maturity from the cash inflow received from such coupon and principal payments.
As per the below table, the 10-year bond has been stripped into 20 coupon strips and one as the main strip.
|
Particulars |
Details |
| Face Value per bond ( in USD) | 10000 |
| Total investment ( in USD Mio) | 1000 |
| Tenor ( in years) | 10 |
| Coupon Rate | 6% |
| Coupon Amount ( in USD Mio) | 60 |
| Total coupon inflows ( in number) | 20 |
| Total Principal Inflows ( in number) | 1 |
| Current Yield | 6% |
| S.No | Year | Cash Flows | Pv of Cash Flows |
| 1 | 0.5 | 60 | 58.00 |
| 2 | 1 | 60 | 56.07 |
| 3 | 1.5 | 60 | 54.21 |
| 4 | 2 | 60 | 52.41 |
| 5 | 2.5 | 60 | 50.66 |
| 6 | 3 | 60 | 48.98 |
| 7 | 3.5 | 60 | 47.35 |
| 8 | 4 | 60 | 45.77 |
| 9 | 4.5 | 60 | 44.25 |
| 10 | 5 | 60 | 42.78 |
| 11 | 5.5 | 60 | 41.36 |
| 12 | 6 | 60 | 39.98 |
| 13 | 6.5 | 60 | 38.65 |
| 14 | 7 | 60 | 37.36 |
| 15 | 7.5 | 60 | 36.12 |
| 16 | 8 | 60 | 34.92 |
| 17 | 8.5 | 60 | 33.76 |
| 18 | 9 | 60 | 32.64 |
| 19 | 9.5 | 60 | 31.55 |
| 20 | 10 | 60 | 30.50 |
| 21 | 10 | 1000 | 508.35 |
Note:
PV of Cash Flows is calculated as
PV of Cash Flows = Cash flows / (1 + Current Yield) ^ Year
- = 60 / (1 + 6%) ^0.5
- = 58.28
Similarly, the calculation for all year
Thus the financial institution can strip a single fixed-paying bond into multiple strips and generate upfront cash flows. If yields go up, the institution will benefit from the fall in prices of such strips and vice versa.
Treasury Strips Maturity
The maturity of Treasury strips is useful in determining the potential gain that the holder of such an instrument earns. Normally the return expected from Treasury Strips is known well in advance as these instruments are discounted instruments redeemable on maturity at par.
Thus if it is held till maturity, returns will be:
Face Value of the Instrument- Price at which the instrument is purchased
If it is sold before maturity, returns would be:
Market Value of the Instrument – Price at which the instrument is purchased
Advantages of Treasury Strips
It offers multiple advantages. A few noteworthy are enumerated below:
- First, Treasury strips are low-risk and highly liquid instruments backed by the US government, which makes them an ideal low-risk product for investors.
- Investment in these instruments is less since these are discounted products redeemable at par value on maturity.
- It is a well-fixed income instrument for investors with a longer time horizon and low-risk appetite and is mostly advised as a Retirement product.
- Helps diversify portfolios and is a risk-reducer tool for overall portfolio optimization.
- It helps manage cash flows properly, avoids mismatches, and is a great tool for financial institutions to manage their asset liability.
- Helpful in creating a zero-coupon yield curve which, in the absence of such strips, requires deriving curves synthetically using sophisticated methods like Nelson seagull, etc.
- It allows the implementation of various trading strategies and the exploitation of arbitrage opportunities in trading by reconstitution treasury strips.
Disadvantages of Treasury Strips
Despite the various advantages noted above, it suffers from certain shortcomings as enumerated below:
- From a liquidity perspective, it is less liquid than treasury coupon bonds issued by the US government.
- Investing in Treasury strips results in a portfolio’s overall modified duration, resulting in interest rate risk from a portfolio perspective.
- It requires taxability in the hands of the investor for income accrued and not on actual income received. The Tax Equity and Fiscal Responsibility Act (TEFRA), 1983, requires holders of such Treasury strips to pay tax on the unrealized accrued income.
- Certain jurisdiction doesn’t differentiate between treasury strips and normal coupon bonds, which make them less attractive as tax is payable on unrealized income in the case of Treasury Strip.
Conclusion
It is an innovative financial instrument that existed way back in the 1970s in US markets, and its origin and development flourished with the need for financial engineering. It involves separating a standard fixed coupon-bearing instrument into coupons and principal so that each coupon becomes a separate Zero Coupon bond.
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This is a guide to Treasury Strips. Here we also discuss the definition and example of treasury strips along with their advantages and disadvantages. You may also have a look at the following articles to learn more –
