Stripping off – investment style

  • Author : John Harper
  • Date : August/September
ABOUT THE AUTHOR: John Harper TEP is a part-time lecturer, delivering face-to-face courses for the step international diploma examinations all around the world

STRIPS is the acronym for ‘Separate Trading of Registered Interest and Principal Securities’. But it also means what it says. Before computers and electronically held instruments, the income coupons on US Treasuries were literally stripped off the paper bond, which represented the capital sum owed to the lender. The concept was developed in the early 1980s by some of the larger US investment houses. Since 1985 all new Treasury bonds and notes with maturities of ten years and longer are eligible to be stripped and are direct obligations of the US government. To that extent they must be regarded as AAA-rated and effectively risk-free.

The principal component of a STRIPS is a promise to pay a fixed sum at a fixed maturity date (e.g. to pay the bond’s owner USD10,000 on 15 May 2040). The interest component is a promise to pay a fixed amount of interest every six months until the bond matures. Treasury STRIPS are therefore regular Treasuries whose principal and interest components have been split and sold separately.

Treasury STRIPS pay no interest. The buyer of a USD10,000 STRIPS purchases a promise to be repaid USD10,000 at a certain date, backed by the ‘full faith and credit’ of the US Treasury. You might buy a USD10,000 Treasury STRIPS maturing in 2040 and today pay perhaps only about USD4,000 for it. On that basis, the average annual yield to maturity (YTM) works out at around 3.3 per cent. Similarly, investors who just want a guaranteed income will buy the interest rights that have been stripped away.

They are very popular in the US as a method of planning for retirement. If you wanted to have available cash of, say, USD50,000 every year between 2015 and 2040, you would purchase STRIPS with that amount of face value maturing in each of those years. The cost at today’s prices may be as much as USD49,500 for the one maturing in 2015, but for the 2040 maturity possibly nearer only USD20,000. Of course an unexpected rise in the rate of inflation might make the outcome less attractive.

Although STRIPS don’t pay interest, the IRS treats them as if they do. According to the tax code, the spread between what you pay for the STRIPS and what you receive at maturity is really interest in disguise. So each year you must report a portion of that profit as if it were income. For this reason, individuals are often advised to hold Treasury STRIPS in retirement plans such as traditional IRAs and 401(k)s, which shelter the income received from taxation every year. The tax is payable on the taxable value only when it is withdrawn from the account. In addition, the ultimate gain is generally exempt from state and local taxation. A range of other investors use these zero coupon bonds or ‘zeros’ for investing, hedging and speculation. This includes commercial and investment banks, insurance companies, pension funds and mutual funds, as well as retail investors.

Zeros have considerably higher sensitivity to changes in interest rates than bonds with the same maturity. The price of STRIPS on the secondary market can therefore fluctuate wildly in times of interest rate fluctuations. This means they are fine if held to maturity, but less useful if they need to be sold earlier.

The STRIPS market is less liquid than the US Treasury bond market. Investors encounter wider bid/ask spreads and are subject to higher commissions. In addition, liquidity may also fluctuate in times of market instability.

In 1997, the UK government also started to issue a form of gilt-edged STRIPS. However, as in the US, HMRC taxes all gains from gilt STRIPS as income on an annual basis. Holders are deemed to have ‘bed and breakfasted’ the STRIPS if they hold it from one year to the next, and any resulting gains (or losses) are taxed as income. Effectively, HMRC deems that the holder sells the stock at the closing price on 5 April, and repurchases the same security on 6 April. This means UK STRIPS are only really suitable for investors who are both capital-rich and low-rate tax payers, and who do not need an annual income from them. Otherwise they are, after all, having to pay income tax annually on income that is deemed to arise but is in fact illusory.

International opinion

This is a regular column supporting the STEP International Trust Management syllabus, on which the author is a lecturer. For more information on this and other STEP qualifications, go to www.step.org/pd


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