office (412) 9679367
fax (412) 967-5958
toll-free 1 (800) 214-3480

4.7 Strips

C

hapter 2 introduced the concept of arbitrage and synthetic coupon bonds. A synthetic coupon bond can be engineered as a portfolio of zero-coupon bonds. The cash flows from the portfolio of zeros exactly match the cash flows of the actual coupon bond. This technique is sometimes called cash matching.

If a coupon bond can be constructed in this manner, the reverse transaction would amount to "reverse"-engineering a coupon bond into its underlying portfolio of zero-coupon equivalents. You therefore create a set of zero-coupon securities with different maturities from a regular T-note or T-bond.

Such securities have become known as strips. "Strip" stands for separate trading of registered interest and principal.

Stripped Securities

Strips are zero-coupon bonds created from coupon bonds. Essentially, each coupon payment and the principal are traded as separate securities.

For example, suppose that you want to earn the default-free yield to maturity for 2.5 years. Any Treasury note or bond can be reduced to a timeline that records the cash inflows to the owner of the security.

On January 15, 1994, the owner of a Treasury note that matures on July 15, 1997, receives the following cash inflows (standardized relative to $100 face value):

Taken component by component, this T-note can be broken down into eight zero-coupon bonds with different maturities. That is, the maturity and face value of each zero are as follows:

Name

Maturity

Face Value

Zero 1

15 July 1994

$4.25

Zero 2

15 Jan 1995

$4.25

Zero 3

15 July 1995

$4.25

Zero 4

15 Jan 1996

$4.25

Zero 5

15 July 1996

$4.25

Zero 6

15 Jan 1997

$4.25

Zero 7

15 July 1997

$4.25

Zero 8

15 July 1997

$100.00

Zero 7 includes the coupon payment and Zero 8 includes the face value. Lumped together, they create a zero-coupon bond with a face value equal to $104.25. If claims could be issued against this T-note, the desired 2.5 year zero-coupon bond could be created for the example considered above.

The Merrill Lynch TIGR

In 1983, Merrill Lynch created zero-coupon bond certificates by purchasing $500 million worth of an existing 30 year T-bond (maturing on August 15, 2013, callable from August 15, 2008). The bond was placed in an irrevocable trust, and claims were issued against all coupon payments and face value.

Merrill Lynch marketed this offer as the "Merrill Lynch TIGR", or a $2.3 billion zero- coupon "Treasury Investment Growth Receipts" on November 10, 1983. The advertised amount was the nominal value of all of the coupon payments and face value associated with the issue. It split off all noncallable coupon payments into 50 different zero-coupon bond issues, each with a face value equal to $30 million, and lumped together the last 10 callable coupon payments plus face value into a "callable" zero- coupon bond.

Soon after the issue proved to be popular, a number of other issues began to be marketed by Merrill Lynch and others in the form of TIGRs, CATS (Certificates of Accrual on Treasury Securities-Salomon Brothers), and other colorful acronyms. Demand was strong, and between 1982 and 1985, approximately $57 billion in par-value Treasuries were stripped.

The term "strip" was not associated with this type of security until the Treasury officially sanctioned the practice. On January 1985, the Treasury, as part of its book entry system, supported the practice of stripping Treasury issues by announcing its own "Separate Trading of Registered Interest and Principal of Securities" program (STRIPS). This program allowed registered dealers to resell individual interest and principal payments from selected T-notes and T-bond issues. This created an even more active strip market.

Quotations for Strips

Strips are quoted in the same way as T-notes and T-bonds. Quotations are relative to a face amount of $100, and the equivalent of two decimal places (which actually represent 32nds) are bid or asked for. That is, if the ask price for a particular strip issue is 93.12, then the quote is 93 + 12/32 for a face amount of 100.

Quotes also include the letters "ci", "np", or "bp" after the strip. This indicates whether the face value of the strip is "coupon interest," a stripped Treasury "note principal," or a stripped Treasury bond principal.

The Treasury sanctions only certain T-note and T-bond issues as qualifying for strips. You can deduce, however, which issues are sanctioned from the letters added after the quotation. For example, in The Wall Street Journal on April 20, 1994 (for April 19, 1994), under the U.S. Treasury strip page includes:

Nov 94 np 97:15 97:16

The maturity date is November 1994 for the principal from a Treasury note, bid price 97+15/32, ask price 97+16/32, change in price 0 (blank) in 32nds.

This is part of one of the earliest Treasury notes that the Treasury sanctioned for stripping. The stripped note is a ten year Treasury note maturing 11/15/1994 with a coupon rate equal to 11 5/8%. The bid/ask for the underlying T-note on this same day was 103:29/ 103:31.

As of April 19, 1994, the remaining coupon payments on this Treasury note expressed relative to a $100 face value were:

As of April 19, 1994, its remaining stripped components had the following cash flows:

and finally the note’s principal component is:

Each component was traded on the strip market and quoted in The Wall Street Journal as follows:

Maturity

Type

Bid

Ask

       

May 94

ci

99.24

99.24

Nov 94

ci

97.15

97.16

Nov 94

np

97.15

97.16

Yield to Maturity (Compounding Daily)

There are 26 days remaining until maturity for the May stripped coupon payment, and its price in decimals is $99.75. The yield to maturity is the (annualized) discount rate that equates the present value of the face amount to the current price:

where

F = Face value

YTM = Yield to maturity (365 days or 366 days)

DM = Days to maturity

In the above example, compounding on a annual basis gives:

F = 100

YTM = 3.5142

DM = 26

Quoted ask price = $99.75 (in decimals)

Online, the strip information is entered as a zero-coupon bond as follows:

The price and the yield to maturity are calculated in the bottom, left-hand corner of the calculator.