U.S. Treasury strippable and non-strippable bonds : an investigation of relative pricing differences

The United States Treasury initiated the Separate Trading of Registered Interest Payments and Principal of Securities (STRIPS) program in February 1985. All Treasury notes and bonds with ten year or greater initial maturities are eligible for stripping. Four major questions are addressed in this dissertation. 1. Does the pricing relationship between STRIPS and the original bonds imply that the STRIPS are priced by a zero tax clientele? 2. Do taxes create differences in values between a bond and a replicating portfolio of STRIPS on an after-tax basis? 3. What is the impact of tax option effect on the relative pricing of a non-strippable bond and a replicating portfolio of STRIPS? 4. Does the eligibility to strip and reconstitute add value to a bond relative to an otherwise identical non-strippable bond? The dissertation shows that: 1. The term structure estimated by STRIPS is a pre-tax term structure. 2. An investor in most situations for a non-flat term structure may prefer to choose between a bond and a portfolio of STRIPS. 3. The pricing differences between strippable and nonstrippable bonds arise due to a tax option effect, an eligibility effect, and the effect of frictions. 4. Price of a non-strippable bond is less than an otherwise identical strippable bond, which implies that stripping and reconstitution is valued by investors.