Treasury STRIPS: Zero-Coupon Bonds and Duration Risk

Key Takeaways

• Treasury STRIPS are created when primary dealers strip a coupon bond into separate interest and principal pieces, each issued a new CUSIP.
• A 30-year STRIPS priced at a 4.50% yield can be bought for roughly $26,400 today to receive $100,000 at maturity with zero reinvestment risk.
• Investors overlook OID phantom income: the annual principal accretion is taxable even though no cash is paid, creating a cash drain in taxable accounts.
• STRIPS carry the government's full credit but also the longest duration at any given maturity; a 100bp yield rise can cause a 20–30% price loss.

What It Is

STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. The program, launched by the U.S. Treasury in 1985, lets eligible financial institutions, typically primary dealers and Federal Reserve member banks, request that a coupon Treasury be "stripped" into its constituent cash flows. A 10-year Treasury with semiannual coupons becomes 21 separate zero-coupon securities: 20 coupon strips plus one principal strip.

Each strip pays a single dollar amount on a single future date. There are no intermediate coupons. Investors typically buy STRIPS through a broker that holds them in book-entry form at the Federal Reserve.

The Intuition

Some investors want to lock in a known dollar amount on a specific future date without reinvestment risk on coupons. A coupon Treasury reinvests interim coupons at unknown future rates, which can drag yield to maturity off target. STRIPS eliminate that uncertainty by giving the investor a single payment at a single date. The trade-off is heightened price sensitivity to interest rates between purchase and maturity.

The institutional appetite for STRIPS comes from liability matching. Pension funds, insurers, and structured-product desks use long-dated STRIPS to fund a known cash outflow decades into the future, because every dollar of duration is concentrated at the maturity date.

How It Works

To strip a Treasury, the holder submits a request through the Commercial Book-Entry System maintained by the Federal Reserve. The Fed cancels the original CUSIP and issues new CUSIPs for each interest and principal payment. The reverse process, reconstitution, recombines the strips back into the original whole bond, provided the holder owns matching coupon and principal pieces. Eligibility for stripping requires the underlying Treasury to be on the Treasury's published list, which generally includes notes and bonds with maturity of more than one year.

Pricing follows the standard zero-coupon formula:

Price = Face / (1 + y/2)^(2 * t)

where y is the annualized yield to maturity (semiannual compounding convention) and t is the time to maturity in years.

A critical feature is original issue discount treatment. Under IRS rules, the holder must accrue and pay tax on imputed interest each year, even though no cash coupon is paid. The annual accrual is calculated from the constant yield to maturity at purchase. This phantom income makes STRIPS painful to hold in taxable accounts.

Duration on a zero-coupon bond equals the time to maturity, so a 30-year STRIPS has roughly twice the duration of a 30-year coupon Treasury. Price moves are correspondingly larger for any change in yields.

Worked Example

A long-duration investor buys a 30-year principal STRIPS at a 4.50 percent yield. The face value is 100,000 USD payable in 360 months.

Price = 100,000 / (1 + 0.045/2)^(2 * 30)
     = 100,000 / (1.0225)^60
     = 100,000 / 3.7868
     = 26,407 USD

The investor pays roughly 26,407 USD today and receives 100,000 USD in 30 years, locking in 4.50 percent compounded semiannually with no reinvestment risk.

If the next year's market yield on equivalent maturities falls to 3.50 percent, the bond's price rises to about:

NewPrice = 100,000 / (1 + 0.035/2)^(2 * 29) = ~36,495 USD

A 100 basis point drop in yields produced a roughly 38 percent gain on the position. The same price sensitivity works in reverse if yields back up.

Each year of holding generates taxable OID even before sale or maturity, calculated from the original 4.50 percent purchase yield.

Common Mistakes

• Holding STRIPS in a taxable account. OID is taxed annually as if interest had been paid. Most investors hold STRIPS in IRAs or other tax-deferred accounts to avoid the cash drain.
• Underestimating duration risk. A 30-year STRIPS can lose 20 to 30 percent of price if long yields rise sharply. The "safety" of a Treasury label does not eliminate market risk before maturity.
• Confusing STRIPS with TIPS. STRIPS are nominal zero-coupon Treasuries with no inflation linkage. TIPS principal grows with CPI but TIPS still pay interim coupons.
• Assuming all Treasuries are strippable. Only Treasuries on the Treasury's published list qualify. Some older issues and most off-the-run securities are not strippable.
• Forgetting reconstitution. Holders of matched coupon and principal pieces can recombine them into the original whole bond if the spread between strip and whole-bond pricing makes it worthwhile. Most retail investors will never do this, but it is a feature dealers exploit.

Frequently Asked Questions

Q: What are Treasury STRIPS in simple terms? Treasury STRIPS are individual zero-coupon bonds created by separating a coupon Treasury bond into its component cash flows. A 10-year note becomes 21 separate securities, 20 coupon strips and one principal strip, each paying a single amount on a single future date.

Q: How do Treasury STRIPS affect investment decisions? STRIPS eliminate reinvestment risk entirely by delivering all return as a single lump sum at maturity. They are used by institutions to match known future liabilities to the dollar. Individual investors can use them to lock in a known real-dollar payoff, but must accept significant price swings if they sell before maturity.

Q: What is a real-world example of Treasury STRIPS pricing? A 30-year principal STRIPS at a 4.50% yield costs roughly $26,407 today and returns $100,000 at maturity. A 100bp drop in long yields next year would push the price to about $36,495, a 38% gain. The same sensitivity works in reverse for rising rates.

Q: How can investors hold Treasury STRIPS tax-efficiently? Keep them inside a traditional IRA or tax-deferred account. STRIPS generate OID that is taxed annually as if interest were received, even though no cash arrives until maturity. Paying that annual tax bill from external cash while the STRIPS compound defeats much of the purpose.

Q: How are Treasury STRIPS different from TIPS? STRIPS are nominal zero-coupon bonds with no inflation protection; they lock in a fixed nominal yield. TIPS are coupon bonds with CPI-linked principal adjustment that provide real yield. Both carry phantom income, but STRIPS are zero-coupon and carry maximum duration risk for their maturity.

Sources

1. TreasuryDirect. "Separate Trading of Registered Interest and Principal of Securities (STRIPS)." https://www.treasurydirect.gov/marketable-securities/strips/
2. U.S. Department of the Treasury. "Treasury Marketable Securities." https://home.treasury.gov/policy-issues/financing-the-government/treasury-marketable-securities
3. Federal Reserve Bank of New York. "Treasury Securities Statistics." https://www.newyorkfed.org/markets/treasury-securities-statistics
4. Internal Revenue Service. "Publication 1212: Guide to Original Issue Discount Instruments." https://www.irs.gov/publications/p1212

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.