Stripped Bonds: Advantages, Disadvantages, and Tax Implications

1. What is it? • Stripped bonds are artificially “manufactured” zero-coupon bonds. • They are “manufactured” when investment bankers buy blocks of coupon-paying bonds (typically long-term government Treasuries) and separate them into two components: • The coupons (which have been “stripped” from the bond) • The principal (the “stripped” bond) • Each component is sold separately. • The principal is sold at enough of a discount to provide a competitive market yield to maturity.

2. When is the use of this tool indicated? • When investors want to be assured of reinvestment at the yield to maturity. • Unless the bond is called or sold before maturity • Investors can better predict and plan for specific accumulated value at the maturity date. • Due to the certainty of the reinvestment rate • Taxable strips are very suitable conservative investments for retirement plans. • Tax-exempt strips are an excellent vehicle for children under age 18 who are subject to their parents’ tax rate on unearned income. • Strips are suitable when a known lump sum is needed at a specific future time.

3. Advantages / Disadvantages • Prices of stripped bonds are more sensitive to interest rate changes than prices of coupon-paying bonds of the same quality and maturity. • The market price of stripped bonds will fall (rise) when market interest rates increase (decrease) much more than the market price of comparable coupon-paying bonds. • The size of the move in the market price associated with a given change in market interest rates will be greater the longer is the term until maturity of the bond. • In periods of historically low interest rates, investors bear considerable risk of sustaining large capital losses in the event market interest rates rise and they are forced to sell the stripped bonds before they mature.

4. Advantages / Disadvantages • Many stripped bonds are callable at the discretion of the issuer. • If a strip is called before maturity, the investor will generally not be able to reinvest the proceeds at the yield to maturity he enjoyed on the stripped bond. • Some strips are issued with call protection to assure investors that the bond will not be called for a specified period. • Corporate and municipal strips are more likely to be callable than U.S. Treasury-based strips.

5. Tax Implications • Interest is subject to tax as it accrues even though no cash is paid until the bond matures or is called. • In the case of a tax-exempt bond stripped after 6/10/87, a portion of the original issue discount may be treated as if it comes from a taxable obligation. • The original issue discount (OID) rules generally determine the amount of interest that accrues each period for tax purposes. • For bonds issued after 4/4/94, OID must be accrued at a constant rate, effectively equal to the yield to maturity. • The accrued interest each period is added to the investor’s basis in the bond. • Gain or loss, if any, upon disposition of the bond prior to maturity is equal to the difference between the sale price and the original issue price plus the accrued interest to the date of sale.

6. Tax Implications • In the case of federal government issues as the underlying securities: • If the interest is U.S. government interest, the interest is exempt from state tax. • If the interest is from the investment banker who “manufactures” the strip, the interest would be subject to state taxation.

7. Alternatives • Stripped federal government securities, which can have many different names: • CATs – Certificates of Accrual on Treasury Certificates • COUGRs – Certificates of Government Receipts • STAGs – Sterling Transferable Accruing Government Securities • STRIPs – Separate Trading of Registered Interest and Principal of Securities • TIGRs – Treasury Investment Growth Certificates • ZEBRAs- Zero-Coupon Eurosterling Bearer or Registered Accruing Certificates • The name depends on the investment banker that “manufactures” the stripped bond.

8. Alternatives • Stripped tax-free municipal bonds • Advantage over original issue zero-coupon municipals: Most of the tax-free strips are not callable. • Virtually all of the zero-coupon municipals are callable. • Therefore, tax-free strips give investors more certainty about the holding period and their reinvestment yield. • Some new tax-free strips are guaranteed by “pre-refunding.” • They are backed by U.S. Treasury bonds. • Payment is guaranteed if the municipality goes bankrupt, or is slow in paying investors when the bonds mature.

9. Alternatives • Target-maturity mutual funds • These are open-end no-load mutual funds that specify a particular termination date. • Require a minimum investment of $2,500 • These funds: • Invest in STRIPs and coupon-paying Treasury bonds that match the specified termination date • Pay little or no interest during the life of the fund • Pay out a lump sum at the fund’s termination date. • Caution –Some funds listed as target-maturity mutual funds are actually hybrid funds that combine STRIPs maturing at specified dates with investments in equities or other assets. • They do not have the same risk, return, and tax features as pure target-maturity mutual funds.