HOW DO STRIPS WORK?

STRIPS are zero coupon securities issued by brokerage firms and based on receipts for Treasury securities.  Any Treasury issue with a maturity of 10 years or longer is eligible for the STRIPS process.

Here is how the process works.  Brokerage firms purchase Treasury securities through the means of book-entry receipts; that is, the Treasury records the firm's ownership of the bonds or notes, but the firm does not actually hold certificates that later need to be redeemed.  Based on its receipts, the firm then strips the principal from the interest and creates zero coupon securities based on portions, or units, of the principal or interest of the security.

Let's take, for example, a 20-year bond with a face value of $20,000 and a 10 percent interest rate.  A brokerage could purchase a receipt for the bond and strip the principal from its 40 semi-annual interest payments.  It would then sell to investors 41 separate zero-coupon securities, each with different maturities based on when the interest payments on the Treasury bond were due.  The zeros would be discounted to the present value using the prevailing interest rate and term to maturity.  If the principal unit of $20,000 was discounted by 10 percent for 20 years, it would sell for $2,973 (ignoring any markup or commissions).  Upon maturity, the principal would be worth $20,000, and each of the interest-backed securities would pay $1,000 (one half the annual interest on the bond).  The brokerage would use its earnings from its Treasury bond to pay the holders of the STRIPS as they mature.

Of course, as with other debt securities, investors do not have to hold the STRIPS to maturity to cash in.  An active secondary market exists, on which individual STRIPS may be traded at market value until maturity.

Next, we will learn what makes STRIPS popular with some investors.