When thinking about U.S. government-issued Treasurys, many investors immediately consider Treasury bills (T-bills) due to their popularity and straightforward nature. However, the world of U.S. Treasurys is quite diverse, offering a range of investments that cater to different needs and strategies.
Beyond the varying maturities of Treasurys, there are also distinct types that have come into focus, especially during 2022 and 2023. For instance, Treasury Inflation-Protected Securities, or TIPS, and I-Bonds have been common choices among investors seeking inflation hedges.
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Yet, one lesser-known but potentially valuable option in this spectrum are Separate Trading of Registered Interest and Principal Securities, or Strips. Here’s all you need to know about Strips as a potential investment and how they can be effectively integrated into a portfolio:
Definition and Overview of Treasury Strips
Unlike a traditional bond, which includes both fixed, semiannual interest payments called coupons and the repayment of the principal at maturity, Strips operate differently.
As their name suggests, Strips are a type of Treasury bond where the periodic interest payments and final principal repayment are “stripped” apart. This means that each interest payment and the final principal payment are treated as separate, individual zero-coupon securities.
By dividing the bond into its constituent parts, Strips allow investors to choose between investing in the bond’s interest payments, its principal, or a combination of both.
“The main feature of Strips is that they are sold at less than par value, and at maturity the investor is paid that value and realizes the income at that point,” says Jim Penna, senior manager of retirement services at VectorVest Inc. “Hence, they are a type of zero-coupon bonds since they pay no interest.”
T-Strips history
Treasury Strips were officially introduced in the United States in 1985. Prior to their formal introduction, some financial institutions were already creating their own “synthetic” zero-coupon bonds as early as 1960, by stripping coupons from regular Treasury bonds and selling the parts separately.
Recognizing the market interest, the U.S. Treasury decided to officially legitimize Strips, streamlining the process and providing investors with a direct and transparent way to invest.
How Treasury Strips work
When a Treasury bond is “stripped,” to become a Strips, its coupon payments and principal are separated and sold as individual securities. Investors buying Strips are thus purchasing either the interest payments or the principal, but not both together as with a standard bond.
Both components are sold at a discount to their face value and do not pay periodic interest. Instead, they are redeemed at face value at the end of the term, with the difference between the purchase price and face value representing the aggregate interest that would have been earned.
“You purchase the Strips components at a discount to face value, and are paid face value when the security matures,” says Michael Ashley Schulman, partner and chief investment officer at Running Point Capital. “The discount effectively acts as the investment’s yield.”
The term of Strips can be quite varied, typically ranging from a few years to as long as 30 years, usually matching the original maturity of the bond from which they were stripped.
As Strips do not pay periodic interest and are bought at a discount, their duration, a measure of interest sensitivity, is equivalent to their maturity. This characteristic makes them more sensitive to interest rate fluctuations compared to bonds with similar maturities that pay periodic interest.
Finally, in terms of credit risk, Treasury Strips are considered very secure. They are obligations of the U.S. government and carry a very low risk of default, similar to other U.S. Treasury securities.
An Example of Strips
“Strips are popular because they are easy to understand,” says Giuseppe Sette, president and co-founder of Toggle AI, a market research firm. “Essentially, you pay a fraction of a dollar today to get back a full dollar in a few years.”
To illustrate how Treasury Strips work, consider a 20-year Treasury bond with a face value of $10,000 and an annual coupon rate of 5%. By becoming a Strips, the $10,000 face value of the bond is separated and sold as a single zero-coupon bond.
An investor might purchase this principal Strips at a price lower than $10,000, say $6,000, depending on current interest rates. At the bond’s maturity in 20 years, the investor would receive the full $10,000 face value, with the $4,000 difference representing the interest that would have been earned over the period.
Additionally, each of the 40 semiannual coupon payments is also separated and sold individually as zero-coupon securities. Investors can purchase these coupon Strips at prices lower than their face value, with the price paid dependent on the time remaining to the coupon payment date and prevailing interest rates.
In this process, the original bond is effectively disassembled into 41 separate Strips, consisting of 40 semiannual coupons plus the principal, each with its own distinct maturity date and price. This allows investors to tailor their investments to their specific needs and views on interest rates.
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Pros and Cons of T-Strips
Strips are a unique investment asset that comes with its own array of advantages and disadvantages, which investors need to weigh against their risk tolerance and time horizons.
One major advantage of Strips is their suitability for duration matching. That is, investors can easily align their investment in Strips with specific, known future financial obligations.
“The benefit of a Strip is it effectively creates a zero-coupon bond with a defined maturity,” says Matt Dmytryszyn, chief investment officer at Telemus, a fee-based investment management and financial advisory firm. “This is beneficial to investors that have a future liability that they want to reserve for.”
For instance, an individual planning for a child’s college education in 10 years can purchase 10-year Strips, providing a reliable and safe investment that matures exactly when the funds are needed.
This duration-matching feature is particularly beneficial for institutions like pension funds and endowments, which often have defined long-term financial commitments and can use Strips to precisely match the timing of future cash flows with their liabilities.
“The important thing to keep in mind before investing is the time frame you choose for your Strips,” Penna says. “Generally, they are used by investors with a long-term outlook.”
However, Strips also come with heightened sensitivity to interest rates, a notable disadvantage in some cases. In an environment of rising interest rates, Strips can experience significant unrealized losses. As a result, the increased price volatility can be unsettling for some investors, particularly if they need to sell the Strips before maturity.
Conversely, in a scenario where interest rates are cut significantly, Strips can appreciate in value considerably. Their long durations and zero-coupon structure make them highly responsive to rate cuts, potentially offering substantial capital gains.
“As zero-coupon instruments, Strips have higher durations than comparable maturity Treasury bonds that contain both principal and interest components,” Dmytryszyn says. “For someone wanting to speculate on interest rates going lower, buying a 30-year Strips would be more effective than buying a 30-year Treasury bond.”
This attribute therefore positions Strips as a potential “flight to safety” investment during economic downturns or recessions, as investors seek assets that benefit from stimulative monetary policies such as interest rate cuts.
“From a more sophisticated point of view, if you believe the Fed might cut rates in the next year, then long-dated Strips might offer a good way to make a profit,” Sette says.
Tax Treatment of Treasury Strips
The taxation of Treasury Strips presents a unique scenario for investors. While these securities do not pay out periodic interest like traditional bonds, they are still subject to taxation on the accrued interest that accumulates over time.
This phenomenon is often referred to as “phantom income.” Essentially, investors are taxed on the interest that the Strips are accruing each year, even though this interest is not actually received until the security matures.
For example, if you purchase Strips at a discounted price of $8,000 with a face value of $10,000 maturing in 10 years, the $2,000 increase in value over the decade is considered taxable income by the IRS, taxed annually as it accrues.
Due to this, many investors find it beneficial to hold Strips in a tax-advantaged account, such as a Roth IRA. In these accounts, the taxation of the accrued interest can be deferred or eliminated, depending on the specific type of account.
Key Points and How to Buy T-Strips
“You can only trade, hold and redeem Strips through financial institutions — i.e., brokers and dealers — that handle government securities and use the commercial book-entry system to hold Strips on behalf of investors,” Schulman says. “However, you cannot purchase Strips from TreasuryDirect or any other government agency.”
When buying Strips through an online brokerage with bond trading privileges, it’s important to consider several key metrics. Notably, investors should keep an eye on the yield to maturity, or YTM, that indicates the expected return if the bond is held until it matures, with a higher YTM often suggesting better returns.
Another metric to watch closely is the Strips’ duration. Duration is expressed in years and can help investors understand how much the price of Strips may fluctuate with interest rate changes.
For 30-year Strips, if interest rates increase or decrease by 100 basis points, the price of the Strips will typically move inversely by approximately 30% of its value.
This high duration indicates a greater sensitivity to interest rate changes, making long-duration Strips like a 30-year option more volatile in response to rate fluctuations.
Finally, for investors looking to stay more hands-off, another option is to buy an exchange-traded fund, or ETF, that holds a diversified portfolio of Strips.
“ETFs provide an easy way to buy diversified baskets of long-term Strips greater than 20 years,” Schulman says. “For example, the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ticker: ZROZ) and the iShares 25+ Year Treasury Strips Bond ETF (GOVZ) focus on Strips of 25+ years, while the Vanguard Extended Duration Treasury ETF (EDV) holds Strips with maturities of 20 to 30 years.”
However, investors should note that unlike single Strips, the corresponding ETFs cannot be held to maturity. These ETFs continually reinvest in a portfolio of Strips to maintain a target maturity band, and thus incur turnover within their holdings.
“For investors looking at Strips as a means of funding future liabilities, buying them directly through a broker is optimal,” Dmytryszyn says. “For investors looking to speculate on the direction of interest rates, ETFs can serve as more liquid means for gaining exposure to Strips.”
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Treasury Strips (T-Strips): What They Are and How to Invest in Them originally appeared on usnews.com
