Trading and Capital-Markets Activities Manual
Profiles: U.S. Treasury STRIPS
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 identification (CUSIP) numbers and may be owned and traded separately.
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.
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 (OTC), with the primary government securities dealers being the largest and most important market participants. A small group of inter-dealer brokers disseminates quotes and broker trades on a blind basis between market participants. Arbitrageurs 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.
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.
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 semi-annual interest payment of $1,000 or a multiple of $1,000. Quotes for STRIPS are quoted in yields to maturity.
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 OTC option, the relative illiquidity of the derivative Treasury security and the option may diminish the effectiveness of the hedge.
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).
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.
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.
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.
The accounting treatment for investments in U.S. Treasury STRIPS is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, with the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING
U.S. Treasury STRIPS have a 0 percent risk weighting. Trademark products have a 20 percent risk weighting.
For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.''
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.
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. Treasury 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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