What are Treasury Strips?

Examples

  • STRIPS is an acronym that stands for Separate Trading of Registered Interest and Principal of securities. These are specific financial products that are carved out of treasury/Sovereign bonds.In simple terms, this is nothing but stripping of the expected cash flow of a bond into multiple individual fixed-income products.Let us take an example of a fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more product with a time to maturity of 10 years. The coupon payment is made annually at a coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more of 8%. Going by the contract terms of this bond, there will be 11 coupon payments in total. These payments can be repackaged into 11 zero-coupon bondsZero-coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more and could be called STRIPS in the financial community. Since the U.S. government distributes these, they are called treasury strips and have the comfort of being reliable and creditworthy.

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Lest consider the cash flow of the simple vanilla bond

Now let’s consider the cash flow when this bond is stripped into multiple strips (treasury strips in the case of sovereign bonds). The new cash flow will be as follows: each coupon payment has become the maturity date for the new zero-coupon bonds stripped from the original Vanilla bond.

Calculations on the treasury strip’s return on investment (ROI) are a bit compelled. There can be 2 cases.

  1. If the treasury strip is liquidated before the maturity date, then

  2. The second scenario is when the treasury strip is held until the maturity date. Then

Advantages of Treasury Strips

  • Have a huge range of maturities: As explained above, treasury strips are carved out of Vanilla bonds. Hence, they are customized by dealers as per the demand and can have a varying range of maturities.These are similar to zero-coupon bonds as they are issued at a fair discount and are matured at face value, as explained in the above example.The cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more is quite simple and direct as there are no interest payments, and face value is received at maturity.This can be invested even in small chunks and hence is quite a favorite among retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more too.One of the best advantages of this financial product is that they are backed by the government and hold the same credibility as Sovereign bonds.Owing to their customization, these strips are the best mechanism for hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more.

Important Points

STRIPS have inherent risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more because of their unique characteristics. Let’s consider these in detail.

  • Credit Risk – Since the US government backs these, they are considered safe and have credibility similar to sovereign bonds. Hence, they are considered free from any default and have no credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more.Interest Rate RiskLiquidity Risk – Compared to Treasury bonds, Treasury STRIPS are less liquid. This may lead investors to pay more in commissions to the brokers. Also, because of the less liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, there is a difference in bid and ask prices, which may lead to 2 major problems- it will be difficult to get in and out at desired prices and to affect the hedge for which these STRIPS were initially bought. Second, it may lead to a liquidity crisis because the high difference in bid-ask price liquidity may fluctuate further. Participants might find it difficult to get their order through. However, STRIPS come up with a unique mechanism owing to their distinct characteristics. A broker can strip or repackage it flexibly to create new demand/supply through restriping at new equilibrium levels.The market for treasury strips has grown into a huge one due to its stability and ease of investment. As per market figures in 1999, of all bonds, 37% of these were held in STRIPS and could be valued at $ 225 billion. Since these can be repackaged and demand-supply can be created, there are sizeable flows even in times of distress like the 2000 dot com bubble burst and the great depression of 2008.Treasury strips are used not only for investments but also by economists, investors, and regulators to measure the zero-coupon Treasury yield curveYield CurveA yield curve is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis). The slope of the yield curve provides an estimate of expected interest rate fluctuations in the future and the level of economic activity.
  • read more. Because of the fungibility that these strips provide, these are not affected by a single underlying security and hence provide a smooth yield curve without any discontinuity. The finance community uses these financial products to extrapolate the curve behavior and forecast the interest rate curves and the economic health and the direction in which it is moving. Two major methods to calculate this curve are – Nelson-Siegel and Fisher – Nychka Zervos, named after the mathematicians who empirically calculated these.

Conclusion

These are high-quality debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more as they provide credit-free interest and have sovereign backing. They enable the investors to enjoy the earnings of treasury bills and bonds with a much lower investment. They are used by portfolio managers to hedge the risks and for asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals.read more, thereby helping generate returns even in volatile markets.

This has been a guide to What Treasury Strips are & their Definition. Here we discuss the examples of treasury strips bonds with calculation, advantages, and important points. You can learn more about it from the following articles –

  • T-BillsBond IndentureSovereign Debt MeaningBond Ladder