AN ASSIGNMENT ON STRIPS

Course: F-504: Fixed Income Securities

Submitted To:

Mrs Nusrat Khan

Associate Professor
Department of Finance
University of Dhaka

Submitted By:

Arjun Kumar Das

MBA, Section B
ID: 21-1095
Department of Finance
University of Dhaka

Date of Submission: July 30, 2020

STRIPS
The term STRIPS refers to the instrument created by the specialists to provide investors with an
alternative way of alternative fixed income securities. It gives investors the most benefit which is
to meet certain objectives mostly difficult in the use of traditional bonds and notes. The STRIPS
are considered as the normal bonds having interest and principal payment. In these instruments,
the interest payments are stripped away and sold separately where principal payment is paid at
the maturity. STRIPS help traders to pay out the exact amount of original coupon and principal
amounts at maturity. They tend to yield capital gains or losses at maturity.
STRIPS in the US security market along with others are affected mainly by tax treatment
differentials and the demand for zeros. These two factors make the STRIPS more valuable to the
investors. Along with this, some other factors create influence on TSRIPS such as term structure,
income tax rates, level of interest rates, bond maturities and yield curve type. Investors get
benefits from TSRIPS when there is increase in term structure, income tax rates, level of interest
rates and when bond maturity is longer and yield curve is steeper.
Features:
Securities & Coupon: Separate Trading of Registered Interest and Principal of Securities are debt
securities and these are created through the process of coupon stripping from principal amount.
Individual Interest: STRIPS help and inform investors in the US along with other countries to
hold and trade the individual interest and principal components of eligible treasury notes and
bonds as separate securities.
Guaranteed cash flow: The buyers or the investors buy the STRIPS to have a guaranteed cash
flow at the end of the maturity as interest payments.
Buyers: Buyers of Separate Trading of Registered Interest and Principal of Securities are pension
funds, insurance companies, banks along with retail investors.
Issuing & Tax concern: STRIPS are normally issued at a discount and they mature at par value.
STRIPS don’t pay actual interest of any kind along with applying the Original Issue Discount
(OID). STRIPS inside IRAs and Tax-deferred retirement plans play an important role in avoiding
phantom tax issue and grow until maturity with no tax result.
History of STRIPS
This was first introduced in the US by US dealers in 1960. STRIPS was created initially by the
physically stripping paper coupons from the bearer bonds and these are sold as separate
securities. They work differently from treasury securities and saving bonds because the US
government does t tend to issue STRIPS directly to the investors. Instead of normal trading, US
governments regarding STRIPS purchase convention treasury securities and then the government
strip the interest payments ways from the principal. Interest payments are sold to the investors as
separate securities from the principal with separate CUSIP members. Along with the US
government, the term STRIPS are also issued and backed by the governments in foreign
countries. In the US, the STRIPS are backed by the full faith and credit.
Treasury STRIPS
As the acronym implies, Treasury STRIPS are created when a bond's coupons are separated from
the bond. The bond, minus its coupons, is then sold to an investor at a discount price. The
difference between that price and the bond's face value at maturity is the investor's profit. The
coupons become separate investments that are sold separately. Treasury STRIPS are issued by
the U.S. Treasury and backed by the U.S. government. They were introduced in 1985, replacing
previous zero-coupon bond issues that were known as TIGRs and CATS. All issues from the
Treasury with a maturity of 10 years or longer are eligible for the STRIPS process. STRIPS
cannot be purchased directly from the government. They can be bought by brokerages for resale
to investors.

Treasury STRIPS are bonds that are sold at a discount to their face value. The investor does not
receive interest payments but is repaid the full face value when the bonds mature. That is, they
mature "at par." STRIPS is an acronym for Separate Trading of Registered Interest and Principal
of Securities. These types of bonds are generally known as zero-coupon bonds since they pay no
interest, or coupon.

Example
The process of detaching the interest payments from the bond is called coupon stripping. The
coupons become separate securities, with the principal payments due at maturity. No interim
coupon payments are made along the way. For instance, a 10-year bond with a $40,000 face
value and a 5% annual interest rate can be stripped. Assuming it originally pays coupons semi-
annually, 21 zero-coupon bonds can be created, including 20 semi-annual coupon payments and
the bond itself. Each stripped coupon has a $1,000 face value, which is the amount of each
coupon. All 21 securities are distinct and are traded separately in the market.

Popularity of STRIPS
STRIPS are a popular choice for fixed-income investors. They have extremely high credit quality
because they are backed by U.S. Treasury securities. Since STRIPS are sold at a discount,
investors do not require a large stash of cash to purchase them. Assuming the STRIPS are held to
maturity, their investors know the precise payouts they'll receive. There is a robust secondary
market for Treasury STRIPS, with individual STRIPS trading at market value until they reach
maturity. STRIPS also offer a range of maturity dates, since they are based on the dates of the
interest payments. If an investor wishes to sell a bond prior to its maturity, the market has
enough liquidity to accommodate the transaction.
Tax Considerations
Generally speaking, taxes are due on the interest earned each year, even though there is no cash
payment until the bond reaches maturity or the STRIPS are sold. However, this tax can be
delayed with a tax-deferred account, such as an individual retirement account (IRA). Each holder
of STRIPS receives a report detailing the amount of taxable interest income earned.