Key Takeaways
- STRIPS are bonds that make a fixed, one-time payment on a set date.
- STRIPS are created by selling individual pieces of larger long-term Treasury bonds.
- STRIPS can be affordable, with a minimum purchase of $100, but any increases in value are taxable when earned, not when the bond matures, which can be avoided by putting STRIPS in tax-deferred accounts.
- STRIPS can’t be purchased directly from the U.S. Treasury but are sold over-the-counter through dealers. Strips can be sold and purchased this way in the secondary market, and there are several ETFs that track indexes of STRIPS.
Definition and Example of STRIPS
Typically, a bond is made up of a series of interest payments capped by a final repayment of the principal used to purchase the bond. The individual interest payments are called “coupons” because bonds did at one time come with physical coupons that could be redeemed for a payment of interest. Digital technology has largely eliminated physical coupons today, but the term remains part of the investing lexicon.
Note
A STRIP, whose acronym comes from the instrument’s full name, “Separate Trading of Registered Interest and Principal of Securities,” is created by taking a Treasury bond with 10 years or more until maturity and breaking it down into individual bonds. They were introduced to the market in 1985.
These new bonds generate one payment at maturity and no interest payments, categorizing them as so-called zero-coupon bonds. In the case of a 10-year Treasury bond making semiannual interest payments, the bond would be divided into 20 individual bonds for the 20 interest payments, and another bond for the repayment of the bond principal. These 21 new bonds are STRIPS, with all of them having fixed, one-time payments on fixed dates.
They are sold at a discount that varies according to the amount of time to maturity. STRIPS can be traded in the secondary market before they mature.
How STRIPS Work
STRIPS can be considered for the fixed-income portion of your portfolio like any other bond because a STRIP essentially is a bond created from another bond. The minimum investment in STRIPS is $100, making them affordable for individual investors who don’t want to tie up a lot of cash.
STRIPS can be good for an investor who wants a fixed payment at a fixed date and wants to know exactly how much income will be produced. Following conventional investment theory, most investors younger than 40 benefit more by focusing on all-stock portfolios, so will likely want to skip STRIPS with their lower returns until they start adding bonds to their portfolios as they age.
Because STRIPS are derived from long-term Treasury bonds, they’re considered very low risk but if interest rates increase, the value of STRIPS will fall in the secondary market, although that’s not a consideration for investors holding the bond until maturity. If inflation takes off, however, the yield of the STRIPS might not keep pace with inflation, no matter how long the bond is held.
Note
In addition to the bonds themselves, there are several exchange-traded funds (ETFs) that track a basket of STRIPS, which can offer more flexibility and trading options than directly holding STRIPS.
These ETFs include the iShares 25+ Year Treasury STRIPS Bond ETF (GOVZ); the Vanguard Extended Duration Treasury Index Fund ETF (EDV), which tracks the Bloomberg U.S. Treasury STRIPS 20–30 Year Equal Par Bond Index; and the Pimco 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ), which tracks the BofA Merrill Lynch Long Treasury Principal STRIPS Index.
Because STRIPS can incur tax charges before maturity, they are most attractive to investors with tax-deferred accounts, such as IRAs. Interest on STRIPS is required to be reported in the year it’s earned even though the bondholder doesn’t receive any payment until the maturity date. Nonetheless, STRIPS could be useful in some taxable accounts for which tax management strategies are in place.
Pros and Cons of STRIPS
Pros
Stable income
Relatively affordable
Relatively affordable
Cons
Have to purchase through a third party
Low returns
Value can decrease if interest rates rise
Pros Explained
- Stable income: STRIPS are nonvolatile and dependable, with a set payment on a fixed date, if held to maturity.
- Relatively affordable: STRIPS are affordable for individual investors, with a minimum entry price of $100.
- Liquid: STRIPS offer good liquidity in the secondary market for investors who don’t want to hold the bonds to maturity.
Cons Explained
- Have to purchase through a third party: STRIPS aren’t sold directly to investors but must be purchased over-the-counter from a broker or investment company.
- Minimal returns: Being low-risk, zero-coupon Treasury bonds, STRIPS don’t pay a high rate of interest.
- Value can decrease if interest rates rise: The value of a STRIPS can fall in the secondary market if interest rates rise, and the yield on a STRIPS might not keep up with inflation.
