Sep 04

Treasury STRIPS. FRM 2007

by David Harper, CFA, FRM, CIPM

FRM |

stripsIntro2

Learning Outcome

    LO 21.1: Compare and contrast the structure of Treasury coupon bonds and Treasury STRIPS, and differentiate between P-STRIPS and C-STRIPS.

STRIPS are Zeros

As explained by TreasuryDirect.gov, STRIPS is an acronym that stands for Separate Trading of Registered Interest and Principal of Securities.

More importantly, STRIPS are zero-coupon securities ("zeros"). Because the U.S. Treasury does not issue zeros directly, STRIPS give investors a way to access long-term zero-coupon instruments that have no credit risk.

Are zeros important? You bet! Zero-coupon bonds are primitive instruments that represent focused exposure to interest rates. A coupon-bearing bond carries reinvestment risk: the risk that paid coupons will be reinvested at lower rates as time goes by. But a zero carries no such reinvestment risk. Instead, a zero carries "pure" interest rate risk. In fact, the Macaulay duration of a zero-coupon bond is equal to its term to maturity; a ten-year zero has a Macaulay duration of ten, at inception (the modified duration is slightly less at 9.7).

When we practice mapping complex instruments, say for purposes of portfolio VaR, we map the portfolio to a set of primitive risk factors. Among these is likely to be zero coupon bonds, in order to capture the portfolio's exposure to interest rate changes.

 

Treasuries are "stripped" to create P-STRIPS and C-STRIPS

Consider a U.S. Treasury note with five years to maturity. Such a note pays coupons semiannually (every six months):

stripsUStreasury2

 

C-STRIP

When the above Treasury note is stripped, each cash flow (ten coupons and one principal payment) becomes a separate zero-coupon security. Under the original bond, the first coupon that pays in six months becomes a C-STRIP: a zero-coupon bond with maturity of six months. Under the original bond, the second coupon pays in one year. This coupon is stripped into a C-STRIP: a zero-coupon bond with maturity of one year. And so on...

stripsCstrip3

 

P-STRIP

The original bond's principal payment is stripped into a P-STRIP: a zero coupon bond with maturity of five years.

stripsPstrip

Bruce Tuckman notes that C-STRIPS are fungible and P-STRIPS are not. Specifically, C-STRIPS may be used to reconstitute other Treasury bonds but P-STRIPS are identified with their original bond (so they trade rich/cheap along with their original bond).

 

Key Takeaways

  • Both C-STRIPS and P-STRIPS are zero-coupon bonds. As such, they are the primary (primitive) instruments used to map complex instruments to interest rate exposures.
  • C-STRIPS "strip" Treasury coupon payments. P-STRIPS strip Treasury principal payments.
  • STRIPS can be illiquid
  • Short-term C-STRIPS tend to trade rich; long-term C-STRIPS tend to trade cheap
  • P-STRIPS tend to trade near fair value

 

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