> Zero coupon bonds result from the separation of coupons from the body of a security.

> Zeros sell at deep discounts from face value. > The difference between the purchase price of the zero and its face value when redeemed is the investor’s return.

> Zeros can be purchased from private brokers and dealers, but not from the Federal Reserve or any government agency.

Creating Zeros by Coupon Stripping

Coupon stripping is the act of detaching the interest payment coupons from a note or bond and treating the coupons and the body as separate securities. Each coupon, or interest payment, entitles its owner to a specified cash return on a specific date; the body of the security calls for repayment of the principal amount at maturity.

The body of the stripped securities and the separate coupons are known as zero coupons or zeros because there are no periodic interest payments on each instrument. After stripping, the body and coupons are sold at a deep discount from their face values. An owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity.

For example, a 20 year bond with a face value of $20,000 and a 10% interest rate could be stripped into its principal and its 40-semi-annual interest payments. The result would be 41 separate zero coupon instruments, each with its own maturity date. The principal would be worth $20,000 upon maturity, and each interest coupon $1,000, or one-half the annual interest of 10% on $20,000. Each of the 41 securities, now possessing a distinct ID number, could be traded separately until its maturity date at prices determined by the market.

Proliferation of Treasury STRIPS

Some Treasury securities were traded in the secondary market without one or more of their interest coupons in the late 1970s. Stripped securities offered investors a financial instrument that had abundant supply, no default risk, and low incidence of being called, or paid off, before their maturity date. However, their popularity raised fears within the Treasury Department that zeros would result in a sizable loss of tax revenues.

Detached coupons and the body of the security were sold at deep discounts, $.05 or $.10 on the dollar. After purchase, an investor claimed a capital loss on the difference between the sale price of the security and its face value, thus reducing the investor’s overall tax liability.

The Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 adjusted the tax treatment of stripped securities to reduce their tax advantage. The Treasury Department then withdrew its objections to coupon stripping, prompting several securities dealers to create new products incorporating receipts for stripped debt securities.

TEFRA also required the Treasury to begin issuing all of its securities in book-entry (electronic) form only, beginning on January 1, 1983. This provision eliminated Treasury issues of bearer notes and bonds with coupons attached. Physical stripping would no longer be possible.

In response, bond dealers began to market receipts that evidenced ownership of Treasury zeros held by a custodian. The first of these receipt products were named Treasury Investment Growth Receipts, or TIGRS. Similar products appeared in 1984, such as Certificates of Accrual on Treasury Securities (CATS) and Treasury Receipts (TRs). However, most of these securities were not exchangeable with other stripped securities, and thus lacked the liquidity customers had come to expect from zero instruments.

In February 1985, the Treasury took a more active role by introducing its own coupon stripping program called STRIPS, an acronym for Separate Trading of Registered Interest and Principal of Securities. The STRIPS program was intended primarily to reduce the cost of financing the public debt by facilitating competitive private market initiatives.

Under the STRIPS program, U.S. government issues with maturities of ten years or more became eligible for transfer over Fedwire. The process involves wiring Treasury notes and bonds to the Federal Reserve Bank of New York and receiving separated components in return. This practice also reduced the legal and insurance costs customarily associated with the process of stripping a security.

In May 1987, the Treasury began to allow the reconstitution of stripped securities.

Part of a Balanced Portfolio

Stripped securities can be purchased only from private dealers and brokers. Although the Federal Reserve provides services to the zero coupon market, it does not actually sell these securities for the Treasury. Financial services companies decide when and what portion of an eligible security are stripped and sold.

Because their increase in value is taxable yearly as it accrues, zeros have become most popular for investments on which taxes can be deferred, such as individual retirement accounts and pension plans, or for nontaxable accounts. However, their known cash value at specific future dates enables savers and investors to tailor their use to a wide range of portfolio objectives.

Source: Federal Reserve Bank of New York.