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Why Treasury Principal and Coupon STRIPS Can Trade at Different Prices

Article Quant Q&A · Author: Pablitorun
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Summary

The document explains why 30-year Treasury principal STRIPS and coupon STRIPS with the same maturity may have different prices. The main explanation is that supply and demand differ between the two cash flows, and their financing rates can differ. The accepted answer describes the price gap as an arbitrage opportunity, while emphasizing that convergence takes decades and that the coupon strip can be much scarcer than the principal strip.

Capturing the spread requires shorting one strip and financing the other. A small yield differential can erase the apparent gain, so the trade depends on borrowing availability and financing costs over the holding period. The document also mentions tax treatment as a possible source of price differences in some countries, but does not establish that it explains the US case. It offers no empirical series or detailed trade analysis, and notes that principal strips often trade richer without making this a rule.

Key ideas

  • Different supply and demand for principal and coupon cash flows can create a price spread between same-maturity STRIPS.
  • Financing rates and the cost of borrowing the shorted strip can eliminate an apparent arbitrage gain.
  • The coupon strip may be much scarcer than the principal strip because its supply comes from the bond's coupon payments.
  • Tax treatment may affect relative strip prices in some markets, but the document does not establish it as the explanation in the US.

Tags

Fixed incomeArbitrageUS markets
Full text
# Why is there a price difference between 30 year principal and interest STRIPS?


# Why is there a price difference between 30 year principal and interest STRIPS?












Sorry if this is obvious, I am not a professional. I like to trade 30 year treasury zero's.

I have noticed that the price for a 30 year principal payment is never the same as a 30 year interest payment. The difference is small (~.3%), and I haven't tracked it long enough to confirm if one is always greater than the other.

Can anyone tell me what is going on here? Is there a tax arbitrage at play here? Is it that the principal is considered slightly more guaranteed than the interest payment? (Or vice versa?)

## Answer by OracleOfNJ (score 8, accepted)

https://quant.stackexchange.com/a/2400

This really is an arbitrage. It is caused by differences in supply and demand between the interest cashflow and the principal cashflow and by differences in the financing rates on the two STRIPS.

As you noted, the price difference is small, and it would take 30 years to guarantee convergence. In addition, the outstanding amount of the 30-year coupon strip (the interest payment) is quite small, since the only source of this cashflow is the 30yr bond itself and therefore the amount available is only half of the annual interest amount of the bond - if you're talking about the current 30yr, only \$250mm can be stripped compared to a \$16 billion principal amount. Therefore, it is currently not particularly attractive as arbs go.

Finally, if you were going to try to capture this arbitrage by shorting the principal strip and buying the coupon strip, you would need to borrow the principal strip and finance the coupon strip. A price difference of 1% is approximately equal to a yield differential on these two instruments of 3 basis points. As a result, if the interest you earned on your short proceeds was just 3bp less than the interest you paid to finance the purchase over the life of the trade, you would not make any money on the trade.

Generally speaking, the principal strips or "P"s usually trade rich to the coupon strips, but this is not a hard and fast rule. At times this arbitrage can become quite large, as much as a 3-5% price difference between two bonds.

## Answer by Shrlck (score 4)

https://quant.stackexchange.com/a/2416

This may not apply in the US, but in some countries the interest income is taxed and the principal isn't, so in some markets the difference amounts to the implicit tax.

## Answer by Kevin Blake (score 0)

https://quant.stackexchange.com/a/77027

Isn't the interest strip taxed at the coupon rate and the principal strip taxed at the inflation rate? If the interest is higher than inflation, then that strip should sell for less due to higher taxation.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.