Stripped Securities

A stripped security is a Treasury bond whose coupon payments and principal repayment have been separated into individual, tradeable pieces. A 10-year Treasury might be “stripped” into 21 individual securities—one for each semi-annual coupon plus one for the final principal repayment. Each piece is a zero-coupon bond with its own maturity.

How stripping works

Financial institutions (typically large dealers) buy Treasury bonds and deposit them with the Federal Reserve’s book-entry system. The institution then instructs the Fed to “strip” the bond—separate each coupon and the principal into distinct securities, each with its own CUSIP number and maturity date.

A $100,000 10-year Treasury with a 4% coupon becomes 21 separate pieces: 20 coupon pieces of $2,000 each (paid semi-annually) and one principal piece of $100,000 (paid at maturity). Each piece can be bought, sold, and held independently.

Zero-coupon advantage

Because each piece is a separate zero-coupon instrument, it pays no coupons—only a lump sum at maturity. A strippable zero maturing in 5 years can be bought at a deep discount (perhaps $80 for every $100 of principal). The investor buys at $80 and receives $100 at maturity, with no interim payments.

Zero-coupon bonds appeal to investors with specific future obligations: a pension fund needing to pay benefits in exactly 7 years can buy a 7-year stripped zero and lock in the rate with no reinvestment risk. The return is guaranteed by the purchase price and the maturity date—there are no interim coupons to reinvest and no variability.

Valuation and duration

Stripped zeros have the highest duration of any bond for a given maturity, because all their return is deferred to maturity. A 10-year stripped zero has a duration of approximately 10 years, whereas a coupon-paying 10-year bond might have a duration of 7–8 years (because coupons reduce the weighted-average time to receive cash).

This high duration means stripped zeros are extremely sensitive to interest-rate changes. A 1% rise in rates can drop a 10-year stripped zero’s price by roughly 10%. This makes them volatile but attractive for investors who are confident rates will fall.

Tax and accounting considerations

Stripped zeros create a tax complication. Even though they pay no coupons, the IRS treats the “phantom” interest accrual as taxable income each year. A $80 stripped zero bought today and maturing for $100 in 5 years accrues $4 of interest per year (roughly), which is taxable to the bondholder even though no cash is received until maturity.

This makes stripped zeros tax-inefficient in taxable accounts but excellent for tax-deferred accounts (IRAs, pension funds, insurance companies). Financial advisors often recommend holding strips only in 401(k)s or similar shelters.

STRIPS nomenclature

The most common stripped securities are the “STRIPS” (Separate Trading of Registered Interest and Principal Securities) created by dealers and the Federal Reserve. There are also older stripped securities with different names (e.g., “Treasury Receipts”), but STRIPS dominate the market.

Liquidity and dealer activity

The STRIPS market is smaller and less liquid than the coupon-paying Treasury market. Prices are quoted by dealers, but the spread is wider and the trading volume is lower. An investor buying or selling a large amount of 20-year STRIPS might need to wait for the right buyer and could face wider bid-ask spreads.

Barbell strategies and duration matching

Institutional investors use strips to match assets to liabilities precisely. A pension fund with a $1 million obligation due in exactly 15 years can buy $1 million par value of 15-year STRIPS and be guaranteed to have the exact amount needed on that date.