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Creating Zeros by Coupon Stripping
Proliferation of Treasury STRIPS
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 coupon 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
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.