Laddering with Treasury STRIPS

By John H. Robinson, Financial Planner

For most of the past two decades, there wasn't much reason to get excited about building a ladder of short- and intermediate-term U.S. Treasury securities. Interest rates were simply too low.

That has now changed.

The recent rise in interest rates has made the old-fashioned strategy of laddering Treasury maturities from one to five years "fashionable" again. For investors who want a portion of their portfolio dedicated to safety and predictable future spending, Treasury STRIPS (also known as Treasury Zeros) can be particularly useful.

U.S. Treasury securities are direct obligations of the federal government. Treasury bills mature in one year or less, while Treasury notes and bonds have longer maturities. Because they are backed by the U.S. government, Treasuries are generally regarded as having essentially no credit or default risk when held to maturity.

They also have an important tax advantage. Interest from U.S. Treasury securities is subject to federal income tax but exempt from state and local income taxes. That can make Treasuries especially attractive to residents of high-income-tax states such as Hawaii, California, Oregon, Connecticut, Rhode Island, and New York.

What Are Treasury STRIPS?

STRIPS stands for Separate Trading of Registered Interest and Principal of Securities.

Treasury notes and bonds normally make semiannual interest payments and return principal at maturity. Under the STRIPS program, those individual interest and principal payments can be separated and traded as individual securities. Each STRIP is effectively a zero-coupon Treasury security that makes a single payment on a predetermined future date.

That feature makes STRIPS ideal for laddering.

Suppose you expect to need $50,000 per year from your portfolio over the next five years. Instead of keeping $250,000 in cash or, God forbid, a bond fund, you could purchase STRIPS scheduled to mature with approximately $50,000 in each of years one through five.

You know exactly when the money will become available and approximately how much you will receive, assuming you hold each security to maturity.

This can also be an excellent way to hedge against interest-rate movements in either direction. If rates rise, each maturing rung gives you an opportunity to reinvest at higher yields. If rates fall, you have already locked in today's yields on the longer rungs of the ladder.

For retirees, I particularly like this approach for setting aside several years of expected portfolio withdrawals. The investor can leave the growth portion of the portfolio invested while knowing that near-term spending needs have already been funded with securities backed by the U.S. government.

There is one tax wrinkle investors should understand. Although STRIPS don't make periodic cash interest payments, the discount generally accrues as taxable original issue discount each year. In other words, you can owe federal income tax on income you haven't yet received in cash.

Still, for investors seeking safety, predictable maturity values, and exemption from state and local income taxes, the return of meaningful Treasury yields has made STRIPS worth another look.  Check out the latest issue of Yield Shopper for the latest yields on Treasury Zeros.

For more information, see the U.S. Treasury's explanation of Treasury STRIPS.