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Waseem Alim

How are STRIPS structured

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 vs. Principal strips

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.

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.

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".