Question

What are some of the advantages and disadvantages (to investors) of STRIPs and TIPs?

Answer 1

ADVANTAGES OF STRIPS:

1. STRIPS always pay out the exact amount of their original coupon or principal amounts at maturity, which makes them ideal funding vehicles for when a definite amount of money is needed at a specific time.

2.  STRIPS can also yield capital gains or losses if they are sold before maturity.

DISADVANTAGES OF STRIPS:

1. Investors who wish to sell their STRIPS before maturity must often dump them at a loss if they can sell them at all, because the secondary market for these securities is often sparsely traded and sometimes nonexistent.

2. Investors who sell STRIPS before maturity may still have to pay taxes on the interest that accrued until the sale date.

ADVANTAGES OF TIPS :

1. Inflation Protection: This is the single largest benefit and the differentiating feature that would cause one to include TIPS in their portfolio.

2. Safety: U.S. Treasury obligations are considered the safest investment in the world.

3. Diversification: TIPS are an excellent diversification choice because they have little or no correlation with most other investments that are typically in an investment portfolio. Combining them with riskier inflation hedges can be beneficial to a portfolio.

4. State and Local Tax Exemption: Like all Treasury securities (i.e. bills, notes, bonds), TIPS are exempt from state and local taxes.

5. Real Rate of Return: Investors are guaranteed a real rate of return because the principal is adjusted for inflation. In other words, if the bond is held to maturity the investor knows he will receive his stated interest percentage (real return) plus the adjustment for inflation.

DISADVANTAGES OF TIPS:

1. TIPS usually carry interest rates lower than other government or corporate securities, so they are not necessarily optimal for income investors.

2. Their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, their utility decreases.

3. TIPS is a higher tax bill. The adjustments of principal are considered income for tax purposes, although investors do not receive the adjustments, but instead receive the coupons that result from them.