What Is a Strip Bond and How Does It Work?

Investors looking for predictable returns often turn to bonds, but some variations offer unique benefits. Strip bonds, also known as zero-coupon bonds, differ from traditional bonds in how they generate returns. Instead of periodic interest payments, these bonds are sold at a discount and pay their full face value at maturity.

This structure makes them appealing for long-term financial planning, but there are important factors to consider. Understanding how strip bonds work, what affects their pricing, and the tax implications can help investors determine if they align with their financial goals.

Principal and Coupon Segregation

Strip bonds originate from traditional bonds but are transformed through a process called stripping, where the bond’s principal and interest payments are separated into individual securities. Financial institutions or government agencies perform this process, creating two distinct investment components: the principal, which represents the bond’s face value payable at maturity, and the coupons, which are the periodic interest payments that have been detached and sold separately.

Investors can purchase either the principal or the individual coupons, depending on their strategy. Someone planning for a future lump sum payout might buy the principal portion, while another seeking regular income could acquire the coupons. Since each component is sold independently, their prices fluctuate based on market conditions, interest rates, and time to maturity.

Government bonds, such as U.S. Treasury securities, are commonly stripped through programs like the Separate Trading of Registered Interest and Principal of Securities (STRIPS). These securities are backed by the U.S. government, making them a low-risk investment. Corporate bonds can also be stripped by financial institutions, though they carry credit risk depending on the issuing company’s financial health.

Pricing Factors

The value of a strip bond is primarily determined by interest rates. Since these securities do not provide periodic income, their price is highly sensitive to rate changes. When interest rates rise, newly issued bonds offer higher yields, making existing strip bonds with lower implied yields less attractive. As a result, their prices decline. Conversely, when rates fall, the price of strip bonds increases because their fixed future payout becomes more valuable relative to lower-yielding alternatives.

Time to maturity also plays a significant role in pricing. The longer the duration, the greater the impact of interest rate fluctuations on the bond’s present value. A strip bond maturing in 20 years will experience more dramatic price swings compared to one set to mature in five years. The present value of the future payout is more heavily discounted the further away it is, amplifying sensitivity to rate changes.

Liquidity is another factor. While government-issued strip bonds, such as U.S. Treasury STRIPS, tend to have an active secondary market, corporate strip bonds may not trade as frequently. Lower liquidity can result in wider bid-ask spreads, meaning investors might receive less favorable pricing when buying or selling. This can be particularly relevant for those who may need to exit their position before maturity.

Tax Considerations

Unlike traditional bonds that provide periodic interest payments, strip bonds generate no cash flow until maturity. Despite this, investors must pay taxes on the imputed interest each year. The IRS treats the difference between the purchase price and the face value as interest income, which accrues annually even though no money is received until the bond matures. This taxation method, known as the original issue discount (OID) rules, means investors must report and pay taxes on “phantom income” long before they actually receive any cash.

For taxable accounts, this can create a cash flow challenge since investors owe taxes on income they haven’t yet realized. To mitigate this, some choose to hold strip bonds in tax-advantaged accounts like IRAs or 401(k)s, where the imputed interest can grow tax-deferred until withdrawal. For those investing through a Roth IRA, the accrued interest may be entirely tax-free if qualified distribution rules are met.

State and local taxes also play a role, particularly for municipal and U.S. Treasury strip bonds. Interest on Treasury securities is exempt from state and local income tax, which can make them more attractive for investors in high-tax states. Conversely, corporate strip bonds do not offer this exemption and are fully taxable at all levels. Investors should consider their overall tax situation when selecting which type of strip bond to purchase.

Differences from Regular Bonds

Strip bonds differ from traditional bonds in how they expose investors to reinvestment risk. Regular bonds pay periodic interest, allowing investors to reinvest those payments at prevailing rates. If rates decline over time, reinvesting at lower yields can reduce overall returns. Strip bonds eliminate this uncertainty by locking in a fixed yield from the outset, ensuring that the investor knows exactly how much will be received at maturity.

Marketability also differs. While conventional bonds often trade with accrued interest, meaning buyers compensate sellers for interest earned but not yet paid, strip bonds trade purely on a discount-to-maturity basis. This simplifies pricing but also makes them more volatile, as their full value is tied to future cash flow rather than ongoing interest receipts. Additionally, since strip bonds lack periodic payments, they are more susceptible to inflation risk. A standard bond provides recurring income that can be reinvested or spent, helping offset rising costs, whereas a strip bond’s fixed payout may lose purchasing power if inflation exceeds expectations.

Acquisition Process

Investors looking to purchase strip bonds have several options. These securities are typically available through brokerage firms, financial institutions, and government programs that facilitate the stripping of bonds. Since they do not trade on public exchanges, investors must go through dealers or specialized bond desks to acquire them, often requiring a minimum investment amount.

Government-issued strip bonds, such as U.S. Treasury STRIPS, can be purchased through the secondary market or directly from financial institutions that participate in the stripping process. These securities are widely available and backed by the U.S. government, making them a common choice for conservative investors. Corporate strip bonds, on the other hand, are less common and may carry credit risk depending on the issuer’s financial stability. Investors interested in corporate strips should assess the issuing company’s credit rating and market conditions before committing capital.