Suppose the Treasury sells $100 million worth of Treasury note with a 10-year maturity and a coupon rate of 10% to an investment bank. The note will make semi-annual interest payments of $5 million and payback $100 million at the end of 10 years. Given that there are 21 payments in total, an investment bank can synthetically create 21 different zero-coupon bond issues. 20 of these are based on the interest payments, and the final one is based on the repayment of principal. The bank then sells the claim on each payment rather than the note as a whole.
Coupon strips refer to the zero-coupon bonds that are backed by the coupon payments (i.e. interest payments by the Treasury), whereas principal strips are backed by the final repayments of principals. The difference is crucial since an investor would have to pay income tax on the coupon strip, whereas they only have to pay capital gains tax on the principal strip.The interest payments are known as "coupons" after their source of cash flow, and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are known as "zero coupon" bonds or "zeros". Most strip bonds are priced at a discount to their maturity value.
In fact, for a taxable entity, holding coupon strips require them to pay income taxes every year (since taxes are paid on interest accrued) even though they do not get repaid till the maturity of the strip. As a result, coupon strips have negative cash flow till maturity.
Bond Stripping process in South Africa
• A primary dealer creates a request to strip a nominal amount of a designated strippable bond, either for its own account or on behalf of a client, and sends the request to the respective Central Depository Participant via the Bond Automated Trading System (BATS) or any other electronic form used for back up purposes.
• The Bond Exchange of South Africa will provide a new strip/reconstitution function on the automated trading system to cater for the primary dealers’ requests and client confirmations. If the primary dealer is initiating a strip or reconstitution on behalf of a client, the client will have to send a confirmation via Bond Automated Trading System (BATS) to its Central Depository Participant confirming that a particular primary dealer will be generating a strip/reconstitution request on their behalf. Alternatively, the primary dealer may initiate a strip or reconstitution for their own account.
• On receipt of the requests and confirmations from the primary dealers and clients, BATS will send the requests on to UNEXcor who in turn will notify the designated Central Depository Participant of the strip/reconstitution transactions.
• Once stripped, coupon and principal strips will be freely tradable in the secondary market on the Bond Exchange of South Africa. These trades will be settled in precisely the same manner as any other bond traded on the Exchange.
See http://www.bondsonline.com/Search_Quote__Center/Treasury_Bonds/Zero_Coupons_and_Strips.php for a somewhat more detailed explanation and an example of the division into separate products discussed above under "How are STRIPS structured".