Why Would An Investor Buy T-STRIPS?

Why Would An Investor Buy T-STRIPS? Most portfolios strike a balance between stocks and bonds. Stocks are carefully selected for their growth potential, but those higher potential returns carry a higher level of risk. That risk is offset with bonds, which are far more stable, though they come with the downside of lower rates of return.

US Treasury Bonds are the gold standard for safety. They are backed by the US government, and they can be purchased for time frames ranging from a few months to a few decades. Bond interest is typically fixed, and it is paid at regular, predictable intervals. That’s helpful for investors who need reliable income.

Most investors are familiar with the three most common types of US Treasury Bonds: short-term Treasury Bills (T-Bills), intermediate-term Treasury Notes (T-Notes), and longer-term Treasury Bonds (T-Bonds). A fourth category, Treasury Inflation Protected Securities (TIPS) are also quite common. These bonds pay variable yields based on the rate of inflation as measured by the Consumer Price Index (CPI).

Treasury STRIPS (T-STRIPS) are less well-known than their more traditional Treasury security peers, but they are growing in popularity. They offer unique benefits that appeal to investors who find standard T-Bonds impractical. So, what are Treasury STRIPS, and why would an investor buy T-STRIPS?

What Are Treasury STRIPS (T-STRIPS)?

Treasury STRIPS (T-STRIPS) is an acronym for Separate Trading of Registered Interest and Principal of Securities. That’s complicated language for a simple concept. Essentially, the interest coupons are removed or “stripped” from a traditional bond, and each interest coupon is traded as an individual security.

Investors holding T-STRIPS don’t earn regular interest payments. Instead, they purchase T-STRIPS for less than their face value, then redeem them for the full face value upon maturity. T-STRIPS are also known as zero-coupon bonds since, by design, they don’t offer the same regular interest payments associated with other types of bonds.

For example, T-STRIPS might look like this:

A bond with a ten-year maturity date and a $50,000 face value might pay five percent interest per year. If the semi-annual coupons are stripped, they create 20 smaller bonds plus the larger zero-coupon $50,000 bond. The face value of the 20 stripped coupons is $1,250.

Each of the 21 bonds is then sold at a discount to the face value, and no interest payments are made. When the bonds mature, investors receive the face value – $1,250 for the smaller bonds and $50,000 for the primary bond.

T-STRIPS shouldn’t be confused with earlier versions of zero-coupon bonds, which included CATS and TIGRs. Those programs ran from 1961 to 1974, and they were eventually replaced by the current design – T-STRIPS – in 1985.

When T-STRIPS were introduced, tax law limited coupon stripping to bonds with more than ten years until maturity. T-STRIPS were met with enthusiasm, and the program was expanded several times. Ultimately, even five-year notes were eligible for T-STRIPS.

What Is The Advantage Of Purchasing T-STRIPS Over Treasury Notes?

Traditional T-bonds, including T-Notes, are featured in many portfolios because they offer the advantages of minimal risk and reliable interest. However, there are disadvantages. One of the biggest is the large cash outlay required to purchase these securities.

T-STRIPS are available for a few hundred dollars rather than thousands, and they can deliver higher yields when conditions are right. More importantly, they mature at face value regardless of market volatility.

What Are The Risks Of Treasury STRIPS?

Securities issued by the United States government are some of the safest investments in the world. The US government has never missed a debt payment, and it has never defaulted on a debt. While in theory, it is possible that some future catastrophe could damage the country’s perfect credit, investors generally consider US government bonds risk-free.

Now, there is a caveat to that “risk-free” assessment. It only refers to the risk of default. Negligible credit risk doesn’t protect T-STRIPS investors from other types of risk, such as liquidity risk and interest rate risk.

The market for T-STRIPS is markedly less liquid than the larger US Treasury bond market. That leads to larger bid/ask spreads, and in many cases, investors pay higher commissions. On the interest rate side, there is minimal risk for investors planning to hold onto T-STRIPS until maturity. However, those that need to sell find that rising interest rates leads to a decline in the value of T-STRIPS.

Are Treasury STRIPS A Good Investment?

The beauty of Treasury STRIPS is that there is plenty of flexibility when it comes to maturity dates. Investors with a specific investment horizon can choose T-STRIPS that fit that timeframe. There is no angst over the amount that will become available when T-STRIPS mature – investors know they will receive the face value.

If investors realize they miscalculated and they require early access to T-STRIPS funds, the bonds can be sold before maturity. There is a secondary market that will pay the going market price, making T-STRIPS relatively liquid.

There is some complexity when it comes to managing taxes for T-STRIPS. Technically, investors are responsible for annual taxes based on the interest income attributed to that year, though the taxes are not usually paid until the bond is sold or redeemed at maturity. Investors who choose to include T-STRIPS in tax-deferred accounts such as IRAs get a pass on tax liability until they take distributions from the account.

It’s important to note that unlike most Treasury Bonds, T-STRIPS aren’t available for direct purchase from the US Treasury. Brokerage firms buy T-STRIPS in bulk, then sell them to investors – often as part of a larger wealth management strategy.

The bottom line is that Treasury STRIPS are a good investment from a risk perspective, and they can offer a reasonable rate of return. However, in most situations, it is unwise to keep an entire portfolio in T-STRIPS. Over time, the lower rates of interest are unlikely to keep up with inflation, which eats away at long-term buying power. In short, T-STRIPS can be a valuable component of a well-balanced portfolio.

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