Zero Coupon Treasury Bonds (STRIPS)

Zero coupon bonds are essentially the same product as all Treasury bonds, but they are paid out in a different manner. Essentially, instead of receiving the interest payments on the bond during the life of the bond, which is typical, the investor will receive the payment in full when the bond matures. This creates a product different from traditional Treasury bonds and corporate bonds.

Face Value and Price of a Bond

Treasury bonds have a face value equal to the amount they will pay out at maturity. For example, a face value of $1,000 is typical for a zero coupon bond. The investor can purchase the bond for a price below this face value and be guaranteed to receive the face value when the bond matures. This completely fixed rate of return would typically be distributed periodically through interest rates. With a zero bond, though, the interest is held until the bond pays out. The earnings on the bond, called the "yield to maturity," would be the same in either scenario. Depending on the length to maturity and interest rate of the bond, the current discounted price will be different. For example, if an investor would like to purchase a bond with a face value of $1,000 and an interest rate of 6.5 percent, the price of the bond will depend on the length of time the investor will hold the bond. If she plans on holding it for 25 years, the price today would be just over $200. If she plans on holding the bond for a shorter period, just 10 years, the price today would be over $500.

Separate Trading of Registered Interest and Principal of Securities

A bond can be broken down into two main interest payments. The first is the yield each month or term. The second is the principal sum that will be repaid. Typically, a bond carries each of these parts with it for its entire lifetime. However, with a STRIPS bond, the separate parts can be broken down. On a 10-year bond, there can be 20 separate interest payments—2 a year—and a principal payment. Instead of trading these all together as one bond, each piece can be traded separately. This provides flexible investment options for a borrower who would like to earn a guaranteed 7 percent interest, for example, in just 6 months.

Good and Bad Sides of Treasury Bond Stability

Ultimately, STRIPS bonds, or zero coupon bonds, carry the backing of the Treasury. In addition to their unique structure, these bonds benefit from the fact that the Treasury cannot practically default on payments. Even if the actual value of a Treasury bond goes down in the market or inflation increases, an investor is guaranteed to earn back the principal sum and the promised interest during the bond's life cycle.

With this low-risk investment comes a disadvantage, however. The interest rates paid out on zero coupon bonds are modest compared to many offered by higher-risk corporate bonds.

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