Treasury STRIPS: State of the Market
Origin of Treasury Stripping
First introduced in 1985, Treasury STRIPS are zero coupon bonds comprising either the principal or individual coupons of U.S. Treasury notes and bonds (termed principal STRIPS and coupon STRIPS, respectively). Initially created by bond dealers literally “stripping” the physical coupons from bearer notes and bonds, the Treasury eventually created the STRIPS program to facilitate the stripping (and later also reconstitution) of US Treasuries and to improve liquidity by, for example, unifying the CUSIPs. Though the Federal Reserve now assists with the logistics of creating and servicing these bonds, the supply of STRIPS is still exclusively controlled by private dealers.
Current Market for STRIPS
Long-dated STRIPS – the most prevalent type being created – are often purchased as a means of adding duration in a liability hedging context. Outside of derivatives, they are one of the most capital efficient ways to add interest rate duration, so typical buyers of STRIPS include corporate defined-benefit pensions and life insurers with USD liabilities.
The influence of corporate pension demand on the STRIPS market was evident in 2018 following the US tax law changes. Corporations were incentivized to contribute to their pension plans, leading to improved funded statuses. As a general rule, better pension funded status corresponds with lower risk appetite and thus a higher fixed income allocation. Often de-risking is also associated with a higher interest rate hedge ratio, or the dollar duration exposure of assets relative to liabilities. As a result, there was sustained demand for STRIPS leading into the September 2018 tax year deadline.
Pension funded statuses have improved some year to date given the equity market rally in the US, though falling discount rates have partially counteracted this. Improved funding may create additional STRIPS demand if equities hold in and discount rates stop declining . As seen in the chart below, STRIPS creation generally occurs when US pension funded statuses are improving.
Despite the recent and forecasted demand for STRIPS, they still trade with less liquidity than other Treasury securities. This is especially the case for coupon STRIPS due to their lower principal amounts. As a result, coupon STRIPS yield more than principal STRIPS, and principal STRIPS more than whole Treasury bonds of the same maturity (see chart below). As demand has abated recently though, the basis between coupon and principal STRIPS – and of both relative to whole Treasury bonds – has widened. Bid/ask spreads have also increased in the STRIPS market indicating higher liquidity premiums and reduced demand.
Upcoming & Potential Developments
Because of the relatively lower liquidity for STRIPS, there are a number of conversations in the market on potential improvements, both for STRIPS specifically and more broadly across fixed income. If implemented, this would have a ripple effect that should tighten the basis between STRIPS and their equivalent whole bonds.
The most immediate, impactful change to the market is dealer sponsored repo facilities, which have been fully approved and are likely to be implemented within the next few months. Sponsored repo enables approved financial institutions to novate certain cleared repo transactions to FICC. In essence, this allows banks and dealers to net repo transactions with sponsored lenders and sponsored borrowers, thus reducing the capital constraints of participating in repo markets. Dealer balance sheets are generally optimized for capital efficiency, and the coupon remnants from creating STRIPS can inhibit this. By improving their ability to utilize balance sheet assets in the repo market, fixed income market liquidity should improve more broadly, including for Treasury STRIPS.
It has also been discussed amongst market participants that the Federal Reserve could allow its open market operations account to be used for stripping, which would reduce the onus on dealers to use their own balance sheets when stripping or reconstituting.
Additionally, the January 2019 TBAC (Treasury Borrowing Advisory Committee) presentation proposed issuing long-dated zero coupon Treasuries as a means to fund increasing borrowing needs in a way that also meets and encourages domestic Treasury demand. The TBAC also suggested ways of increasing liquidity in the STRIPS market, such as making coupon and principal STRIPS fungible.
These proposals admittedly range from very preliminary to near implementation, but are a clear acknowledgement that there is room for improvement in the market structure for fixed income trading. And while Treasury STRIPS are an important part of today’s pension fixed income landscape, there may be enhancements still to come.
 “Separate Trading of Registered Interest and Principal of Securities”
 As of March 31, 2019, there was $301 billion of outstanding STRIPS, of which $291 billion was from Treasury bonds (versus $10 billion of Treasury notes).
 The rule of thumb relationship between discount rates and funded status: lower discount rates reduce funded status because the duration of a plan’s liabilities is generally greater than the duration of their assets.
 Fixed Income Clearing Corporation (FICC), a subsidiary of the Depository Trust & Clearing Corporation (DTCC) which handles processing and clearing of fixed income transactions.
 The System Open Market Account (SOMA) contains the Federal Reserve Bank’s assets acquired through open market operations.
Following the Fed’s announcement, please see below for market views from the Global Fixed Income, Currency & Commodities Team (GFICC):
Consistent with our and the market’s expectations, the Federal Open Market Committee (FOMC) maintained the Fed Funds rate target range of 2.25% ‐ 2.50%.
The May FOMC statement contained changes to the current economic assessment in order to reflect improvement in growth and employment data, but a deceleration in inflation and sequential weakness in Q1 consumption and investment data. The Committee continues to exclude a formal balance of risks from the statement. In addition, the Committee remains “patient” in regards to determining the next policy adjustment in light of “global economic and financial developments and muted inflation pressure”. In a separate implementation note, the Board of Governors voted to cut the interest rate on excess reserves (IOER rate) by 5bps to 2.35% in order to maintain the Fed Funds rate within the target range and prevent the effective Fed Funds rate from trading too close to or above the target range. This change is more technical in nature as a function of money market dynamics and should not be considered a rate cut or a change in the stance of monetary policy.
We can break the statement into two parts:
Chair’s Press Conference
Chair Powell highlighted the improved growth backdrop, diminishing risks related to trade and global developments and easing in financial conditions over the past few months. In addition, the Chair expressed a positive outlook for US growth and the broader economy, but with limited signs of overheating. The main focus of the conversation was on the inflation side of the mandate. Chair Powell detailed the recent path of inflation and explained that the slowdown in core PCE in Q1 as being driven mostly by transitory factors.
The Chair and the Committee remain comfortable with the current stance of policy. The Chair clearly stated and repeated multiple times that the Committee does not see a strong case to move rates in either direction at this time. Questions that attempted to draw parallels between “insurance rate cuts” in the 1990s outside a recession were not validated by the Chair, which viewed this cycle as unique to prior cycles.