STRIPS & TIPS

1. STRIPS & TIPS Dan Huang Ben Misley

2. U.S. Treasury – A Background • Huge influence on the investment world • Issues bills, bonds, and notes • Considered to have no default risk as the U.S. government has never defaulted

3. U.S. Treasury Investments • STRIPS and TIPS are creative investment vehicles issued by the Treasury that offer different investment advantages beyond the normal issuance of standard bills, bonds, and notes • STRIPS: Separate Trading of Registered Interest and Principal of Securities • TIPS : Treasury Inflation-Protection Securities

4. STRIPS - History • CATS: introduced by Solomon Brothers in August 1982. • TIGRs: created by Merrill Lynch • Process: sold individual receipts tied to each separate coupon payment and the principal purchase treasury bonds and deposit them in a bank custody account Strip the bonds into coupon and principal

5. STRIPS History II • Other investment banks also invented their own receipts called trademark zero-coupon Treasury security • Limited liquidity in the secondary market • There existed default risk • TRs: issued by a group of primary dealers in the government market • The settlement required physical delivery • In February 1985, the Treasury carried out STRIPS program

6. Security Par: $100 million Coupon: 10%, semiannual Maturity: 5 years Cash flow Coupon: $5 million Receipt in: 6 months Coupon: $5 million Receipt in: 1 year Coupon: $5 million Receipt in: 5 years Maturity value: $100 million Receipt in 5 years Zero-coupon Treasury securities created Maturity value: $5 million Maturity: 6 months Maturity value: $5 million Maturity: 1 year Maturity value: $5 million Maturity: 5 years Maturity value: $100 million Maturity: 5 years

7. STRIPS-features • Minimum amount: $100 • Investment increment should be multiples of $100 • The components can be reassembled into a fully constituted security • the CUSIP numbers of interest components are different from the CUSIP numbers of principal components and fully constituted securities

8. STRIPS-features • Interest earned on STRIPS must be reported in the year in which it is earned • Some countries consider the interest from principal strips as capital gain which enjoys a preferential tax treatment

9. STRIPS - Benefits • Zero-coupon security backed by Treasury • No credit risk • Good for investors who want to receive a known payment on a specific future date • No reinvestment risk because the payment to the investor only occurs at maturity. • Tax-deferred accounts such as individual retirement accounts • Non-taxable accounts such as pension funds

10. STRIPS – Conclusion/Summary • The coupon and principal payments are “stripped” from a T-bond and sold as individual zero-coupon bonds • STRIPS are debts of the U.S. government so no default risk • Good investment choice for pension funds and retirement accounts though the gain is subjected to federal tax

11. TIPS • Treasury Inflation-Protected Securities • Securities issued by the Treasury (bonds or notes) • Protected from inflation by adjusting principal and coupon payments accordingly • Designed to protect the purchasing power of the investor • Created in 1997 by the U.S. Treasury

12. TIPS – How It Works • TIPS uses the Consumer Price Index (CPI) as a standard for inflation measurement • Each coupon payment (and eventually the principal) are adjusted for inflation or deflation by multiplying the principal value by the inflation rate

13. TIPS – Example

14. TIPS - Benefits • No default risk, as they are offered by the U.S. Treasury • No inflation risk  real rate of return is protected as coupon payments and principal payments are adjusted by yearly inflation (as stated by CPI)

15. TIPS – Hedging Inflation Risk • TIPS are used as a way to hedge inflation risk • However, as it is known with other hedges, such as futures contracts, while downside is limited, the upside is taken away as well • With TIPS, when deflation occurs, our security value decreases proportionally • With a normal bond, deflation would be a good thing as rates are locked in and our real rate of return would increase

16. TIPS - Summary • “Safest investment in the world” • No default risk • No inflation risk • However, because of these advantages, TIPS do not offer a high return

17. Similarities of STRIPS & TIPS • Both issued by the Treasury without default risk • Interests of both securities are taxable • Both offer unique advantages beyond normal treasury securities of bonds, notes, and bills • STRIPS – Zero-coupon security backed by Treasury • TIPS – Protects purchasing power of investor

18. Questions?