How Do Strip Bonds Work?

Definition of the Strip Bond

United States treasury issues are divided into three groups--bills due in less than one year, notes due in less than 10 years, and bonds due from 10 to 30 years. Strip bonds are created from federal treasury notes and bonds. They are created in large quantities for institutional clients.
Once stripped, the securities are not technically treasury issues but are securities backed by United States treasury issues.

Financial Engineering Creates Strip Coupons

The actual stripping process is uncomplicated. Bankers create a trust by creating a trust and dedicating all the coupon payments payable to a trust. This is the income portion. The corpus or principal portion is made payable into another trust. This corpus holding is one form of the common zero coupon bond or residual. The pricing of the two new securities is based upon the present value of all the cash flows that the holder is expected to receive. The tax consequences of the two holdings are more complicated, but generally the coupon tax stream is purchased by entities outside the United States while the zero coupon bond is held in tax-exempt and tax deferred accounts. The practical effect is to create two volatile trading vehicles that can be used to exploit periods of both high and low interest rates. Customers expecting higher interest rates buy the coupon portion so they may reinvest the coupon payments during higher interest rate periods. The residual holder benefits greatly when interest rates decline and the yield on his discount is higher than any investible yield available in the open market.

Market for Stripped Coupons Continue to Expand

Over 16 countries use zero coupon bonds as part of their cash flow management. Canada is the most advanced user where even treasury bill issuance can be created from stripped coupons. Strip coupons have been swapped or combined with variable rate securities and other derivatives. This produces financial instruments with features particular to international corporations, annuity products and cash flow management needs.
One of the most interesting derivatives created is the zero coupon mortgage backed security. Because of the variability of interest payments and irregular pay-down of principal these fixed income instruments have extreme volatility.