Coupon Stripping Explained: 2025 Guide with Examples and Pricing Insights

Thomas J Catalano, a Certified Financial Planner (CFP) and Registered Investment Adviser in South Carolina, founded his financial advisory firm in 2018. His extensive experience spans investments, retirement planning, insurance, and comprehensive financial strategies.

Understanding Coupon Stripping in 2024

Coupon stripping is a financial process that separates a bond’s scheduled interest payments from its principal repayment, effectively creating multiple individual securities. When a bond undergoes coupon stripping, it transforms into a zero-coupon bond—commonly called a strip bond—while each coupon payment becomes its own zero-coupon security.

Key Highlights

• Coupon stripping divides a bond’s coupon interest and principal repayment into two distinct zero-coupon securities.
• Because strip bonds don’t pay interest periodically, investors avoid reinvestment risk.
• In the U.S., stripped Treasury bonds are known as STRIPS (Separate Trading of Registered Interest and Principal of Securities).
• For taxation, the IRS treats the accrued value at maturity of strip bonds as interest income.

How Coupon Stripping Operates

This technique involves purchasing a bond and separating its principal and interest components into standalone securities that can be traded independently. The original bond is restructured into several zero-coupon or strip securities, each with different maturity dates.

The process is financially beneficial when the combined value of the stripped parts exceeds the bond’s original price. Otherwise, coupon stripping might not be profitable.

Each coupon payment entitles its holder to a specific cash amount on a predetermined date, while the principal is repaid at maturity.

The market price of a strip bond depends on the issuer’s creditworthiness and the present value of its maturity amount, influenced by the time remaining and current interest rates. Longer maturities tend to have lower present values, and lower interest rates increase the present value of zero-coupon bonds.

Strip bonds are highly sensitive to interest rate changes because they lack periodic interest payments, resulting in greater price volatility compared to traditional coupon bonds.

Practical Example of Coupon Stripping

In U.S. Treasury securities, coupon stripping is widely practiced and referred to as STRIPS. For instance, an investment bank holding a $50 million Treasury note with a 5% annual coupon over five years can strip this bond into six zero-coupon bonds: one $50 million bond maturing in five years and five $2.5 million bonds maturing annually over the next five years. Each bond trades at a discount relative to its maturity timeline.

Important Considerations

Coupon stripping can also tailor larger bonds with fixed interest rates into smaller bonds with varying rates to meet specific investor preferences, a method commonly used in the mortgage-backed securities (MBS) market.

Zero-coupon bonds created through stripping do not provide periodic interest payments; investors receive a lump sum at maturity. The difference between purchase price and maturity value represents the investment return, which is taxable as interest if held to maturity.

Even without periodic interest payments, investors must annually report imputed interest to the IRS, increasing the bond’s cost basis. Selling the bond before maturity may result in a capital gain or loss.

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