Treasury Receipts and STRIPS

With your understanding of how Treasury securities pay semiannual interest, you can now see how those individual payments can be separated into standalone zero-coupon instruments.

STRIPS (Separate Trading of Registered Interest and Principal of Securities)

STRIPS are created when financial institutions "strip" a coupon-bearing Treasury into separate zero-coupon components. Each individual interest payment and the principal payment become distinct securities with unique CUSIP (Committee on Uniform Securities Identification Procedures) numbers.

Example: A 10-year Treasury note paying semiannual interest can be stripped into 21 separate securities: 20 interest strips (one for each semiannual payment) and 1 principal strip.

Think of it this way: Imagine taking a coupon book with 20 payment slips and tearing each slip out individually. Each slip becomes its own tradeable security, plus the final "IOU" for the principal is another one. That is exactly what stripping does to a Treasury bond.

• The STRIPS program was initiated in 1985 for Treasury securities with maturities of 10 years or longer
• STRIPS trade in the secondary market through brokers and dealers

STRIPS Tax Treatment

Even though STRIPS pay no periodic interest, the investor must report imputed (phantom) interest as ordinary income each year:

• The annual accretion of discount (the increase in value toward par) is taxable each year as ordinary income
• This follows the same original issue discount (OID) rules as other zero-coupon bonds
• Like Treasury Inflation-Protected Securities (TIPS), STRIPS are often held in tax-deferred accounts to avoid annual phantom income taxation

Exam Tip: Gotchas

• Both STRIPS and TIPS create phantom income. You owe taxes annually on the accretion even though no cash is received. This is why both are commonly held in tax-deferred accounts like IRAs.
• STRIPS cannot be purchased directly from TreasuryDirect. They are only available through brokers and dealers, unlike regular Treasury securities.

Treasury Receipts (Pre-STRIPS Era)

Before the Treasury STRIPS program existed, broker-dealers created their own zero-coupon Treasury products:

• They purchased Treasury securities, placed them in a trust, and sold claims on the individual interest and principal payments
• These had proprietary names:
  • TIGRs (Treasury Investment Growth Receipts), created by Merrill Lynch
  • CATS (Certificates of Accrual on Treasury Securities), created by Salomon Brothers

Key distinction: Treasury receipts are not direct obligations of the U.S. government. They are backed by Treasuries held in trust, which introduces a layer of counterparty risk (the trust holding the securities).

Think of it this way: With STRIPS, you own a piece of an actual Treasury security. With a Treasury receipt, you own a claim on a Treasury held by someone else. If that "someone else" (the trust) has problems, your claim could be affected. STRIPS eliminated that middleman.

Exam Tip: Gotchas

• STRIPS are direct obligations of the U.S. government backed by full faith and credit. Treasury receipts (TIGRs, CATS) are NOT direct obligations; they are trust instruments backed by Treasuries.
• If the exam asks whether a "Treasury receipt" carries the full faith and credit guarantee, the answer is NO. Only STRIPS carry the government's direct backing.

STRIPS vs. Treasury Receipts