One of the most intriguing opportunities in the Treasury market today involves an investment with no regular interest payments and significant volatility—but it offers the potential for substantial gains when interest rates decline.
Enter the world of STRIPS—Separate Trading of Registered Interest and Principal of Securities—a type of zero-coupon Treasury bond. Unlike traditional Treasury bonds, where investors receive periodic interest payments, STRIPS allow investors to trade solely on the principal, with the interest portion stripped away.
In July, a record $14.7 billion worth of STRIPS were created, pushing the total market value to an all-time high of $515 billion, according to data from the Treasury Department. As of Thursday, outstanding STRIPS were valued at $513.7 billion, based on LSEG data.
Notably, STRIPS are not issued directly by the Treasury Department. Instead, large financial institutions like J.P. Morgan Securities create them by separating traditional Treasury bonds into zero-coupon securities in response to investor demand. The volume of STRIPS has been steadily increasing, fueled by the expansion of financial markets and rising government spending, with significant growth observed since 2018.
The recent surge in the creation of zero-coupon Treasuries underscores the market's increasing appetite for risk as the Federal Reserve approaches its first rate cut in years. Lower interest rates typically stimulate lending and economic activity, encouraging investors to take on more risk. Zero-coupon bonds, like STRIPS, offer the potential for greater gains than traditional Treasuries when rates fall, though they also come with higher risks if market conditions do not align with expectations.
Here’s how STRIPS work: Investors purchase these bonds at a deep discount relative to their face value, unlike traditional Treasuries that offer periodic interest payments and are sold closer to face value. For example, an investor might pay $700 for a 20-year zero-coupon bond with a $1,000 face value. At maturity, the investor receives the full $1,000, with no interim payments.
Zero-coupon Treasuries, such as STRIPS, typically have long maturities, often 20 to 30 years. This long duration appeals to investors who anticipate significant interest rate cuts by the Federal Reserve. As rates decrease, the price of these bonds can rise sharply if sold before maturity, with the extended term providing more time to realize these gains.
“Mathematically, mechanically, it just has a lot more exposure to interest rate risk, which is why it’s so popular now,” says Phillip Wool, head of portfolio management at Rayliant Global Advisors. “Right now, people want to bet on when the Fed is going to pivot and how extreme that pivot will be.”
The extended duration of STRIPS also makes them attractive to liability-driven investors, such as pension funds and insurance companies, which can align their long-term liabilities—such as pension payouts—with the windfall from a maturing bond. Additionally, they are often used to meet other future financial obligations, such as funding college education expenses.
With the prospect of declining interest rates, demand for long-duration assets like zero-coupon bonds is expected to increase. “I think it’s natural that you would see the demand pick up for longer duration assets, and zero-coupon bonds are the epitome of that,” says Josh Barrickman, co-leader of Vanguard’s $1.5 trillion fixed-income indexing business for the Americas.
The Vanguard Extended Duration Treasury Index ETF (EDV), which packages zero-coupon Treasuries into an exchange-traded fund (ETF), offers a more accessible way for investors to participate in this market. The ETF saw net inflows surge to $247 million in July, compared with $54 million during the same period the previous year. It includes zero-coupon U.S. Treasury securities with maturities ranging from 20 to 30 years and charges a 0.06% annual fee.
Other notable STRIPS ETFs are managed by Pimco and BlackRock’s iShares.
Before diving into zero-coupon Treasuries, it's crucial to understand the associated volatility and risks. For example, Vanguard’s ETF has experienced an average standard deviation of 22.78% over the past three years, reflecting the wide range of potential returns. The ETF lost 39% in 2022 as interest rates rose but gained 1.4% the following year.
To put this in perspective, compare the standard deviation of this ETF to the approximately 13% standard deviation of an ETF tracking the S&P 500.
Barrickman acknowledges the volatility of these products. “I think there’s obviously good momentum in the space...but these products can be very extreme. They’re not appropriate for a lot of investors. It’s a very specific use case.”
Additionally, investors should be aware of the tax implications. Although zero-coupon bonds do not make cash payments until maturity, investors are required to report and pay taxes on the imputed interest—the difference between the bond's purchase price and its face value—each year.
In summary, while zero-coupon Treasuries like STRIPS offer the potential for significant gains, they come with substantial risks, including high volatility and tax considerations. Investors should weigh these factors carefully before investing in these instruments.
