Types of Zero-Coupon Bonds and Government Securities

Many brokerage houses introduced in the early 80s derivative zero-coupon bonds to be used mainly in retirement accounts. They are called derivative securities because they get their value based on another underlying security.

A stripped security is an example of a derivative security. A derivative security is a zero-coupon bond is created and sold by brokerage firms, and are based on payments of interest and principal separate from Treasury notes or bonds  that are kept in escrow.

Stripped government securities
In 1982 both the Salomon Brothers and Merril Lynch created the zero-coupon stripped treasury securities. To create their respective securities, brokerage firms bought long-term U.S. Treasury bonds and kept them in escrow. Then, they sold zero-coupon bonds that represented an ownership interest in the underlying Treasury bonds (held in escrow) and their interest payments. Renouncing to coupon payments of U.S. Treasury bonds created these securities.

An important distinction of stripped zero-coupon securities is that they are not supported by faith or credit from the U.S. Government. Treasury bonds are supported by the U.S. Government, but zero-coupon securities are merely a product of brokerage houses.

Salomon?s products was negotiated under the name Certificate of Accrual on Treasury securities (CATs), and Merril Lynch?s stripped zero-coupon security was sold under the name Treasury Growth Receipts (TIGRs). Other brokerage firms followed with their own stripped zero-coupon securities naming them with different feline acronyms. The greatest disadvantage for these stripped zero-coupon securities is the brokerage firms lack of liquidity.

Competing dealers did not negotiate other brokerage firm securities, therefore, to improve stripped zero-coupon bonds liquidity a group of main dealers in the Treasury bond market decided to issue generic securities.

These securities were called Treasury receipts, and were not associated by any of the participating dealers (Fabozzi and Fabozzi).

In 1985 the US Treasury announced its own and separate Trading of Registered Interest and Principal (STRIP) program. Assigned Treasury bonds could be deprived to create zero-coupon treasury bond.

STRIPs are Treasury securities that have their coupons and principal payments apart, which is the base to create zero-coupon bonds. Since the US Government has direct responsibility over these securities, these tend to have lower yields than the brokerage firm?s stripped zero-coupon securities. Above all, Treasury strip securities offer a greater responsibility than generics offered by brokerage firms.

In the late 80s, Salomon Brothers created the stripped federal agency zero-coupon bonds. The brokerage firm bought $750 million in FICO (Financing Corporation) bonds, and deprived them of interests to later sell them as zero-coupon FICO strips.

The Congress created the FICOs with the purpose of raising funds for the Federal Savings and Loan Insurance Corporation (FSLIC) which had financial problems. FICO zeros were not assigned credit rates through the rating companies, but were considered as relatively safe because of the congress? support to FICOs and FSLICs. Thus, yields in FICO zeros were relatively higher than those of Treasury strips.

Agency strips such as FICO zeros can be bought through brokers and are negotiated over-the-counter in the secondary market.

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