What are STRIP Bonds?

7 September 2009 No Comment Print This Post Email This Post

Bonds called Treasury Strips have buttressed many portfolios during the recent stock market downturn. As fear replaces greed as the driving force in the market, panicked investors are seeking safety, and one of the safest investments is a U.S. Treasury bond. Investors compete to buy these bonds, driving up their price. This is normal when the economy is moving toward deflation. A key reason for owning Treasury Strips is to protect portfolios in deflationary times.

Strips are modifications of regular Treasury bonds. Regular Treasuries consist of two components. The principal component is a promise to pay a fixed sum at a fixed maturity date (e.g., to pay the bond’s owner $10,000 on May 15, 2024). The interest component is a promise to pay a fixed amount of interest every six months until the bond matures. Treasury Strips are regular Treasuries whose principal and interest components have been split and sold separately. For example, if you want a $10,000 Treasury Strip, you can buy just the principal component of a regular $10,000 Treasury bond. The interest components will be sold to other investors. Think of a Treasury Strip as a regular Treasury bond with its interest components “stripped” away.

Thus Treasury Strips pay no interest. The buyer of a $10,000 Treasury Strip gets only a promise of $10,000 at a certain date, backed by the full faith and credit of the U.S. Treasury. In the absence of interest payments, buyers of Strips benefit from a reduced purchase price. You might buy a $10,000 Treasury Strip maturing in 2024 and pay only about $6,200.

Treasury Strips provide safety of principal: the U.S. Treasury has never defaulted on a bond obligation, and Treasury securities are generally considered safer than AAA-rated corporate bonds. They are inexpensive to buy, and once bought, there is no further cost, assuming you hold the Strip to maturity.

For retirees, Treasury Strips can fill the gap between expected income and expected expenses. If you expect to retire in 2014 with annual expenses of $52,000, along with Social Security and pension income of $42,000 per year, you can buy Treasury Strips maturing every year for 15 years, each with a maturity value of $10,000. The $10,000 per year from your maturing Strips, plus the $42,000 from your Social Security and pension, will cover your expenses.

Because Treasury Strips pay just the principal amount at maturity, covering this income gap costs less with Strips than with regular Treasuries. Strips sell at a discount to their value at maturity so a portfolio of 15 Strips, one maturing in each of the next 15 years for $10,000 each, would currently cost about $119,000. A ladder of regular Treasury securities with the same maturity dates would cost far more because they pay periodic interest as well as the return of principal.

Strips can pose one tax complication. Although they 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 Strip and what you receive at maturity-your profit-is really interest in disguise. So each year you must report a portion of that profit as if it were income. For this reason, many ACA members advise their clients to hold Treasury Strips in retirement plans like traditional IRAs and 401(k)s, which shelters the income received from taxation every year. The tax is payable on the taxable value only when it is withdrawn from the account.

U.S. Treasury Strips aren’t right for everybody. But for many clients of ACA members, Strips can be a reliable way to close the income gap in retirement. And with enough years of Treasury Strips in their portfolio, investors can afford to wait for their equity investments to recover, reducing the chance of having to sell them at a loss.

Guest contributor – Stewart Farnell, Ph.D, CFP®   Boulder, CO< –>