Zero-Coupon Bonds and STRIPS

Most bonds pay a regular coupon every six months and return face value at maturity. A zero-coupon bond skips the coupons entirely: it pays nothing until maturity, at which point it pays face value, and it's sold today at a price below that face value so the entire return to the buyer is the gap between the discounted purchase price and the eventual payout. A $1,000 face-value zero maturing in ten years might sell today for around $600, with the $400 difference representing ten years of compounded return.

STRIPS (Separate Trading of Registered Interest and Principal of Securities) apply the same idea to ordinary coupon-paying government bonds: a dealer splits a single bond's cash flows into individual pieces — each coupon payment and the final principal repayment — and trades each piece separately as its own zero-coupon instrument. This lets an investor buy exposure to a single specific future cash flow, at a single specific maturity date, without any of the bond's other cash flows attached.

A worked example

A 10-year Treasury bond paying semiannual coupons has 21 total cash flows (20 coupons plus principal). Stripped into STRIPS, each of those 21 cash flows becomes its own zero-coupon bond with its own maturity date and its own discounted price, letting an investor who only wants exposure to, say, the payment due in exactly 6 years buy just that one piece rather than the whole bond.