Pricing Strips and the Term Structure

Abstract

Using the data on coupon bonds provided in the note, students are asked to estimate the value of portions of the bond (stripping coupons and principal) and deal with the fact that the term structure of interest rates is not flat. There is also discussion on the general nature of stripping bonds. Excerpt UVA-F-0925 Rev. Dec. 4, 2018 Pricing STRIPS and the Term Structure In the early 1980s, investment banks such as Merrill Lynch and Salomon Brothers began offering what were effectively zero-coupon bonds by “stripping” US Treasury issues (i.e., separating the coupons from the principal payments). Once separated, each coupon and each principal payment became a separate zero-coupon bond. In these cases, the investment banks held the underlying US Treasury note or bond and paid out the coupon or principal as it was received. Known as receipt products, these bonds had been created by a number of investment banks and were recognized by such feline names as CATS, TIGRS, COUGARS, and LIONS. These products were almost default-free because the investment banks just passed through the flows to investors, but there was still some default risk since the payments were made by the investment banks to investors. Such almost-default-free financial products provided ideal vehicles for investors such as pension funds and insurance companies, which may not have wanted to deal with the problems of reinvesting the coupon payments that accompanied US Treasury bonds. Spurred by the innovations of Merrill Lynch and others, the US Treasury, in 1985, introduced its own coupon-strippable program by designating some of its notes and bonds eligible for stripping. Under this program, for US government securities (coupon bonds) with maturities of 10 years or more, dealers who held the original coupon bonds were allowed to separately register individual coupon payments and principal as individual securities. The result was that purchasers were able to receive the payments directly from the US Treasury and not from the investment banks, as in the case of the CATS, and so forth. Known as STRIPS (Separate Trading of Registered Interest and Principal of Securities), these products became the dominant zero-coupon instrument. A US Treasury strip was a claim to cash flow at a single maturity date. The cash flow for the strip was either from the coupon or the principal payment of existing Treasury securities. In 1986, the US Treasury allowed dealers to reconstitute an original bond by purchasing all the coupon and principal STRIPS and then registering it as the original coupon bond. This bond could then be traded as a coupon bond. It is important to note that the US Treasury did not directly issue STRIPS. They could not be purchased directly from the US Treasury, but rather from dealers who bought US Treasury coupon bonds directly and then registered the coupons and principal payments as individual securities. These were then sold through dealers in the secondary market. . . .