Zero-coupon notes and bonds are not issued by the US Treasury. Instead, “Treasury zeros” are created by financial institutions and government securities brokers and dealers through the Treasury’s STRIPS program.
Separate Trading of Registered Interest and Principal of Securities (STRIPS) are synthetic zero-coupon securities that are produced by separating (stripping) the interest components (TINT) and the principal component of eligible US Treasury notes and bonds and then selling the individual components with a redemption value of $100 and multiples of $100 thereafter as separate securities, discounted to their face value. They are “reconstituted” in appropriate minimum or multiple increments of $100 and represent the direct obligations of the US Treasury.
All US Treasury notes, bonds and inflation-protected securities (TIPS) are eligible for stripping, generally at any time from their issue date until maturity date. When a Treasury fixed-principal note or bond or a TIPS is stripped through the Federal Reserve commercial book-entry system (CBES), each interest payment and the principal payment becomes a separate zero-coupon security with its own identifying number that can be traded separately.
STRIPS result in a profit for the dealer when the price of the stripped bond is lower than the sum of present value of its stripped components. If the price of a T-note or T-bond is lower than the sum of the prices of its stripped components, arbitrage trades between the two will be profitable.
Short-term coupon STRIPS trade at lower yields whereas long-term coupon STRIPS trade at higher yields compared to matched-maturity principal STRIPS. While coupon STRIPS yields are on average smaller than the yield on principal STRIPS for short maturities – with an absolute yield difference of up to 10 bps, this relationship reverses for longer maturities above five years with differences around 10 bps. Despite the large and relatively liquid STRIPS market, arbitrage transactions do not eliminate these yield differences.