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GENERAL
DESCRIPTION
STRIPS are
zero-coupon securities
created by the U.S. Treasury by physically separating the principal
and interest cash flows. This process of separating cash flows from
standard fixed-rate Treasury securities is referred to as "coupon stripping."
Similar "trademark" securities with such acronyms as CATS
and TIGRs are created by investment
banks.
CHARACTERISTICS
AND FEATURES
STRIPS is the U.S. Treasury's acronym for "Separate Trading
of Registered Interest and Principal Securities," the Treasury's program
developed in 1985 to facilitate the stripping of designated Treasury
securities. All new Treasury bonds
and notes with maturities of 10 years and longer are eligible to be
stripped under this program and are direct obligations of the U.S. government.
Under the STRIPS program, the holder of any eligible security can request
that the U.S. Treasury create separate book-entry
instruments for all of the principal and interest cash flows. The principal
and interest portions of these instruments are assigned separate CUSIP
numbers and may be owned and traded separately.
Trademark Products
Trademark products, which predate the STRIPS market, are
stripped Treasury securities created by investment banks. In August
1982, Merrill Lynch marketed its Treasury Income Growth Receipts (TIGRs)
and Salomon Brothers marketed its receipts as Certificates of Accrual
on Treasury Securities (CATS). Other investment banks followed suit
by issuing their own receipts. These products were created by purchasing
Treasury securities and depositing them in a trust. The trusts then
issued receipts representing ownership interests in the coupon and principal
payments of the underlying Treasury securities.
Since the start of the STRIPS program in 1985, creation
of trademark products such as TIGRs and CATS has ceased, and STRIPS
now dominate the market. Trademark products are, however, still traded
in the secondary market.
USES
STRIPS and other zero-coupon instruments can be tailored to meet a wide
range of portfolio objectives because of their known cash-flow value
at specific future dates. Specifically, they appeal to investors who
want to lock in a terminal value without incurring the risk associated
with reinvesting intervening cash flows. They also appeal to investors
with definite opinions on interest rates, as prices of STRIPS are highly
sensitive to changes in interest rates. Due to this high sensitivity
to interest-rate changes, disproportionately large long-maturity holdings
of Treasury derivatives such as STRIPS, CATS, or TIGRs in relation to
the total investment portfolio or total capital of a depository institution
would be considered an imprudent investment practice.
DESCRIPTION
OF MARKETPLACE
The STRIPS program provides that all stripped securities
be maintained in a book-entry format. For maintenance and transfer purposes,
each marketable Treasury security has a unique identification (CUSIP)
number. Under STRIPS, each principal and interest component is assigned
a separate CUSIP number. All STRIPS are traded over the counter, with
the primary government securities dealers being the largest and most
important market participants. A small group of interdealer brokers
disseminates quotes and broker trades on a blind basis between market
participants. Arbitragers continually monitor the prices of STRIPS and
underlying coupon bearing bonds, looking for profitable opportunities
to strip or reconstitute. Price transparency is relatively high for
STRIPS since several information vendors disseminate prices to the investment
public.
Market Participants
A wide range of investors use zeros for investing, hedging,
and speculation. This includes commercial and investment banks, insurance
companies, pension funds, and mutual fund and retail investors.
PRICING
The prices of STRIPS, CATS, and TIGRs are quoted on a discount basis,
as a percentage of par. Eligible securities can be stripped at any time.
For a book-entry security to be separated into its component parts,
the par value must be an amount which, based on the stated interest
rate, will produce a semiannual interest payment of $1,000 or a multiple
of $1,000. Quotes for STRIPS are quoted in yields to maturity.
HEDGING
Zeros are typically hedged in the futures or options markets,
or by taking a contra position in another Treasury security. The effectiveness
of any hedge depends on yield
curve and basis risk. Also, if a position in zeros is hedged with
an over-the-counter option, the relative illiquidity of the derivative
Treasury security and the option may diminish the effectiveness of the
hedge.
RISKS
Many factors affect the value of zeros. These include the
current level of interest rates and the shape of their term structure
(interest-rate risk), bond maturities (rate sensitivity or duration),
and the relative demand for zero-coupon bonds (liquidity).
Interest-Rate Risk
Increases in the level of interest rates increase the
advantages of stripping. This is because the constant-yield
method applied to premium bonds results in a lower price than linear
amortization does. Zeros have higher sensitivity to changes in interest
rates than bonds with the same maturity. Because they are zero-coupon
bonds, their duration equals their maturity. Duration measures the percentage
change in price for a given change in rates. The higher the duration,
the higher the potential volatility.
Liquidity Risk
The STRIPS market is significantly less liquid than the
U.S. Treasury bond market. Investors encounter wider bid/ask spreads
and are subject to higher commissions. In addition, liquidity may fluctuate
significantly in times of market instability. However, since a dealer
can strip or reconstitute bonds in a fairly flexible manner, if zero-coupon
prices diverge too far from their equilibrium levels, a new supply can
be created or reduced through the stripping and reconstitution process.
Trademark products may have an uncertain marketability,
as some may be eligible to be purchased only though the sponsoring dealer.
CATS, however, are listed on the New York Stock Exchange, enhancing
their liquidity. The market for zero-coupon Treasuries is more retail-oriented
than the rest of the market. This often results in wider trading spreads,
smaller transaction size, and less liquidity.
Credit Risk
As an obligation of the U.S. Treasury, STRIPS are considered
to be free from default (credit) risk. Trademark products such as CATS
and TIGRs are collateralized by the underlying U.S. Treasury, but whether
they are considered "obligations" of the U.S. Treasury is uncertain.
Proprietary products should be reviewed individually to determine the
extent of credit risk.
LEGAL LIMITATIONS FOR
BANK INVESTMENT
U.S. Treasury STRIPS are a type I security with no limitations
on a bank's investment. Trademark products are proprietary products,
so legal limits vary. Appropriate supervisory personnel should be consulted
on specific issues.
REFERENCES
Fabozzi, Frank J., and
T. Dessa Fabozzi, eds. The Handbook of Fixed Income Securities. 4th
ed. Chicago: Irwin Professional Publishing. Federal Reserve Regulatory
Service, vol. 1, 3-1562. Gregory, Deborah W., and Miles Livingston.
"Development of the Market for U.S. Trea-sury STRIPS." Financial Analyst
Journal. March/April 1992. Nagan, Peter S., and Kenneth A. Kaufman.
"STRIPS-An Exciting New Market for Zero-Coupons." ABA Banking Journal.
Stigum, Marcia L. The Money Market. 3rd ed. Burr Ridge, Ill.: Irwin
Professional Publishing. Woelfel, Charles J. Encyclopedia of Banking
and Finance. 10th ed. Cambridge, England: Probus Publishing Company.
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