Treasury STRIPS - Explained
What are Treasury STRIPS?
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Table of ContentsWhat are Treasury STRIPS?How Doe Treasury STRIPS Work?Stripping Coupons to Form STRIPSHow Well Are STRIPS Known?Taxation on STRIPS
What are Treasury STRIPS?
STRIPs is an acronym for Separate Trading of Registered Interest and Principal security. Treasury STRIPS are fixed-income securities (they pay fixed-income on maturity) which are purchased below their face value and offer no interest in the form of coupon payments before maturity. There are otherwise known as zero-coupon based treasuries as investors are not paid semiannually. STRIPS are gotten when the coupon payments on bonds and notes are separated from the principal investments. Yields on this investment are gotten from the difference between the face value of the bonds or notes and the discounted prices at which they were bought. Yields are usually gotten if held till the original security matures.
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How Doe Treasury STRIPS Work?
First established in 1985, Treasury STRIPS are backed by the U.S. government and are thus deemed to be low-risk investments. Most STRIPS are tax-free at both federal and state levels, thus making them a viable substitute for both Certificates of Accrual on Treasury Security (CATS) and Treasury Investment Growth Receipts (TIGRs) which were the most bought zero-coupon based debt instruments. Both securities, as seen above, require the investor to pay taxes even when the investment is not necessary liquid before maturity. STRIPS are purchased at the secondary market from private brokerages and are mostly derived from treasuries with a maturity of more than ten years. Although Treasury STRIPS are backed by the U.S. government, it cannot be purchased directly from the treasury department.
Stripping Coupons to Form STRIPS
A coupon is said to have been stripped if the interest payment on it has been removed to form a separate security. This act is popularly termed coupon stripping. These new securities are then sold below face value with zero-coupons and are repaid at face value at maturity. An example would be a bond with a nominal value of $20,000, with a maturity length of 5 years and an annual interest rate of 2%. This kind of bond can be stripped as it meets the minimum requirement of ten years. If this is done, then the private brokerage can pull out 10 Treasury STRIPS and one main bond, making it a total of 11 securities. Mathematically, this is: Treasury STRIPS= 2 coupons per year x 5 years =10 coupon-based securities + Main bond = 11 securities. *Coupons are paid semiannually. In a case like this, each STRIPS will have a nominal value of $1000, and each of them will be traded separately in the market, including the main bond.
How Well Are STRIPS Known?
STRIPS are very popular investments and can be said to be on an equal range with notes and bonds in some cases. They are low-risk since they're backed by the U.S. government, and most of them are sold at discounts which are savoury to investors. Also, the fact that it is a fixed-income security makes it possible to calculate beforehand the payout at maturity. Also, STRIPS are very liquid, so investors can easily sell their shares off the market before maturity if they so wish.
Taxation on STRIPS
STRIPS generally incur income taxes from the government before maturity, even when the profits are generally qualified for capital taxes. However, some accounts (tax-deferred accounts and non-taxable accounts) qualify for tax-free investments. STRIPS investors are updated frequently on the income interest which they earn even before maturity.