What Is a Strip Bond and How Does It Work?

Bonds are debt instruments where an issuer borrows money from investors, promising to repay the principal amount, or face value, at a specified future date, often with periodic interest payments. Strip bonds are a distinct type of fixed-income security that operates differently. This article explains strip bonds, their creation, attributes, and forms.

What is a Strip Bond

A strip bond is a financial instrument created from a traditional bond by separating its individual interest payments and final principal repayment into distinct securities. This process is called “coupon stripping.” Each separated component, whether a coupon payment or the principal, transforms into its own unique zero-coupon bond, which does not pay periodic interest.

Instead of regular interest payments, investors purchase zero-coupon bonds at a discount to their face value. The return is realized at maturity when the investor receives the full face value. The difference between the discounted purchase price and the face value at maturity represents the earned interest. For example, a $1,000 face value bond purchased for $800 yields a $200 return at maturity.

Each stripped coupon payment becomes a separate security maturing on its original payment date, providing its face value. Similarly, the principal portion, often called the “corpus” or “residual,” also becomes a zero-coupon bond, maturing on the original bond’s maturity date. Investors acquire the right to a single future cash flow.

How Strip Bonds are Created

Strip bonds are not directly issued by the original bond issuer. Instead, financial institutions, such as investment banks, create them by acquiring existing, high-quality, coupon-paying bonds. They then separate the bond’s future cash flows—each scheduled coupon payment and the final principal payment—into standalone securities.

Each separated cash flow is assigned a unique identifier and sold individually as a zero-coupon bond. For example, a 10-year bond paying semi-annual interest generates 20 coupon strips and one principal strip, totaling 21 separate zero-coupon securities. The original conventional bond ceases to exist once this stripping process is complete. The aggregate value of all stripped components equals the value of the original unstripped bond.

The financial institution holds the underlying conventional bond in a book-entry system and issues receipts to investors for the specific stripped components they purchase. This allows investors to buy precise future cash flows tailored to their needs without owning the entire original bond. This process transforms a single bond into multiple distinct investment opportunities, each with its own maturity date and face value.

Characteristics of Strip Bonds

Strip bonds are zero-coupon instruments, meaning they do not distribute periodic interest payments. Investors purchase them below their face value, and their return is realized from receiving the full face value at maturity. The difference between the purchase price and maturity value represents the total interest earned. For instance, a $1,000 face value strip bond acquired for $700 yields $300 in accrued interest.

Strip bonds have heightened sensitivity to changes in interest rates. Because all of the bond’s return is received at maturity, without interim payments, strip bonds have a longer duration than coupon-paying bonds of similar maturity. This longer duration means their market price fluctuates more significantly with shifts in prevailing interest rates. When interest rates rise, their value declines more sharply; conversely, their value increases more substantially when rates fall.

The pricing of a strip bond is determined by discounting its future face value to the present using current market interest rates. This discount reflects the yield an investor earns if the bond is held until maturity, implied by the difference between purchase price and face value. The Internal Revenue Service (IRS) considers the annual increase in value of a zero-coupon bond as “imputed interest” or “phantom income.” Investors must report and pay taxes on this accrued interest annually, even without cash payments. This tax treatment, known as Original Issue Discount (OID) rules, can make strip bonds less suitable for taxable accounts, but they are advantageous in tax-deferred accounts like IRAs or 401(k)s, where taxes on accrued income are deferred until withdrawal.

Forms of Strip Bonds

The most common strip bonds in the United States are Treasury STRIPS, which stands for “Separate Trading of Registered Interest and Principal of Securities.” These are created from U.S. Treasury bonds and notes, debt obligations issued by the U.S. government. Treasury STRIPS are backed by the full faith and credit of the U.S. government, making them among the safest investments in terms of credit risk, as the risk of default is minimal.

While the U.S. Treasury does not directly issue STRIPS, it designates certain Treasury notes and bonds as eligible for stripping by financial institutions. This allows for the creation of a wide range of zero-coupon securities with varying maturities, catering to diverse investment horizons. For example, a 30-year Treasury bond can be stripped into 60 semi-annual interest components and one principal component, each becoming a unique Treasury STRIP.

Beyond Treasury STRIPS, other forms of strip bonds exist, created from corporate or municipal bonds. The stripping process is similar, separating interest and principal payments into individual zero-coupon securities. However, the underlying credit risk of these corporate or municipal strip bonds depends on the financial health and creditworthiness of the issuing corporation or municipality. Unlike Treasury STRIPS, which benefit from government backing, these types of strip bonds carry the inherent credit risk of their specific issuer, meaning a greater possibility of default compared to U.S. government-backed securities.