Hi, I am a Level II candidate. I take Fixed Income class but can’t understand why P-strip and C- strip with the same maturity and liquidity don’t have the same yield. I guess some people here has a better understanding than me. Thanks in advance!
One reason I can think of is that principal and coupon are generally taxed differently for taxable investors. P-strip has a tax advantage so it is priced higher(e.i., has lower yield) compared to a C-strip which has otherwise similar characteristics.
I don’t think there is any difference in the taxation of the components of a STRIP. I think the pricing difference is due to reconstitution. You can take STRIP components and put them back together to create the original security, but you can’t substitute any of CI/NP/BP for the other one. Thus, I can’t make a reconstituted T-note by buying CI for all the coupon payments and then buying a whole bunch of CI on the same date for the NP. Since any date will have lots more issues with coupons than with principal, the NP/BP are generally priced higher, particularly if the reconstituted bond is valuable for some reason (like on special repo).
Hey Joey, The differential tax treatment is about treating the maturity value (minus Price) as a capital gain, especially if it is P-strip. It is not universal. But for taxable investors (may be I should add non-US investor) P-strips generally offer a trade off between favorable tax treatment and yield.
If you mean non-US investor - I have no idea about the tax differences in investing in US Treasury STRIPS for non-US investors. You may well be right. In the US we didn’t straighten out all these cap gains/income tax issues on strips until early 80’s (I think). Edit: If that’s the case, it would be interesting to do a study attributing price differences to the various sources. One thing I am sure about is that trying to arb the difference between say a CI and an NP would be a painful way of trying to make money.