A. Describe the process of stripping treasury securities B. Run through an example C. Discuss the...

A. Describe the process of stripping treasury securities

B. Run through an example

C. Discuss the tax treatment as well as reconstituting a bond

Expert Solution

A. Treasury STRIPS are created when a bond's coupons are separated from the bond. The bond, minus its coupons, is then sold to an investor at a discount price. The difference between that price and the bond's face value at maturity is the investor's profit.

B.The process of detaching the interest payments from the bond is called coupon stripping. The coupons become separate securities, with the principal payments due at maturity. No interim coupon payments are made along the way.

For instance, a 10-year bond with a $40,000 face value and a 5% annual interest rate can be stripped. Assuming it originally pays coupons semi-annually, 21 zero-coupon bonds can be created, including 20 semi-annual coupon payments and the bond itself. Each stripped coupon has a $1,000 face value, which is the amount of each coupon. All 21 securities are distinct and are traded separately in the market.

C.Taxes are due on the interest earned each year, even though there is no cash payment until the bond reaches maturity or the STRIPS are sold.

However, this tax can be delayed with a tax-deferred account, such as an individual retirement account (IRA). Each holder of STRIPS receives a report detailing the amount of taxable interest income earned

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