STRIPS (Treasury)
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds created by stripping the coupon and principal cash flows of eligible Treasury notes and bonds into separately tradable instruments, each representing a single future payment.
The STRIPS program, formally established by the U.S. Treasury in 1985, allows eligible Treasury notes and bonds to be separated into their individual cash flows and traded as standalone zero-coupon instruments. A 10-year Treasury note paying semiannual coupons, for example, can be stripped into 20 separate coupon STRIPS — each representing one semiannual interest payment — plus one principal STRIP representing the face value payment at maturity, yielding 21 distinct zero-coupon securities from a single original instrument.
Each STRIP is a direct obligation of the U.S. government and trades at a discount to its face value. The price of a STRIP reflects the present value of a single future payment discounted at the applicable zero-coupon spot rate for that maturity. A STRIP maturing in 10 years with a face value of $1,000 might trade today at roughly $610 if the 10-year spot rate is approximately 5%, illustrating the compounding mathematics of zero-coupon pricing.
The formula for a STRIP price is: Price = Face Value / (1 + r/2)^(2n), where r is the annualized spot yield and n is the number of years to maturity, with semiannual compounding consistent with U.S. Treasury market convention.
STRIPS serve several distinct market functions. Life insurance companies and pension funds with known long-duration liabilities use long-maturity STRIPS to create precise duration matches without reinvestment risk — since STRIPS pay no interim coupons, there is no uncertainty about the rate at which coupons must be reinvested. This asset-liability matching application makes STRIPS disproportionately popular with liability-driven investors.
STRIPS are also used by the Federal Reserve and academics as inputs to construct the Treasury zero-coupon yield curve, which is fundamental to interest rate modeling and derivatives pricing. The ability to observe the market price of a zero-coupon cash flow at every maturity point makes STRIPS invaluable for bootstrapping a complete term structure.
One important nuance is that while STRIPS held in tax-deferred accounts are straightforward to manage, STRIPS held in taxable accounts require investors to report the annual phantom income — the accretion of the discount — as ordinary income each year even though no cash is received. This tax treatment makes STRIPS in taxable accounts suitable primarily for tax-exempt or tax-deferred investors, and it is a frequently overlooked cost for retail investors who encounter STRIPS without understanding the tax mechanics.