ZERO COUPON BONDS

Creating Zeros by Coupon Stripping Coupon stripping is the act of detaching the interest payment coupons from a note or bond and treating the coupons and the body as separate securities. Each coupon, or interest payment, entitles its owner to a specified cash return on a specific date; the body of the security calls for repayment of the principal amount at maturity.

The body of the stripped securities and the separate coupons are known as "zero coupons" or "zeros" because there are no periodic interest payments on each instrument. After stripping, the body and coupons are sold at a deep discount from their face values. An owner benefits only from the difference between the purchase price and the payment received upon sale or at maturity.

For example, a 20 year bond with a face value of $20,000 and a 10% interest rate could be stripped into its principal and its 40-semi-annual interest payments. The result would be 41 separate zero coupon instruments, each with its own maturity date. The principal would be worth $20,000 upon maturity, and each interest coupon $1,000, or one-half the annual interest of 10% on $20,000. Each of the 41 securities, now possessing a distinct ID number, could be traded separately until its maturity date at prices determined by the market.

Proliferation of Treasury STRIPS Some Treasury securities were traded in the secondary market without one or more of their interest coupons in the late 1970s. Stripped securities offered investors a financial instrument that had abundant supply, no default risk, and low incidence of being "called," or paid off, before their maturity date. However, their popularity raised fears within the Treasury Department that zeros would result in a sizable loss of tax revenues.

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.

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