Adjusted free coupon

What Is Adjusted Free Coupon?

An "Adjusted Free Coupon" refers to a segment of a bond's future cash flow, typically an individual interest payment (coupon), that has been separated, or "stripped," from the bond's other components. While not a universally standardized term, it conceptually represents a standalone future payment derived from a larger fixed income security. In essence, it transforms a periodic coupon into a single, discrete zero-coupon bond, which is then independently valued and traded. This practice falls under the broader category of bond valuation and allows investors to target specific future payouts without holding the underlying bond's full stream of payments.

History and Origin

The concept of separating bond components, leading to what an "Adjusted Free Coupon" represents, originated in the private sector before being formalized by government entities. In the 1970s, financial firms began physically "stripping" the paper coupons from bearer bonds and trading these coupons and the bond's principal separately. Early examples included Treasury Investment Growth Receipts (TIGRs) and Certificates of Accrual on Treasury Securities (CATS), created by investment banks like Merrill Lynch.¹¹

The U.S. Treasury formalized this practice with the introduction of the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program. Although earlier iterations of "STRIPS" existed in 1961, these were discontinued.¹⁰ The modern STRIPS program was officially initiated on February 15, 1985.⁹ This marked a significant development, as it allowed investors to trade the individual principal payment and interest components of eligible Treasury bonds and notes as distinct, direct obligations of the United States. The Treasury's willingness to support stripping followed changes to tax law in 1982 that addressed the tax treatment of the discount accretion on zero-coupon securities.⁷, ⁸ The official history of this program is documented by TreasuryDirect.⁶

Key Takeaways

• An "Adjusted Free Coupon" represents an individual, detached interest payment from a bond, valued as a standalone zero-coupon security.
• The concept is directly related to bond stripping, most famously seen with U.S. Treasury STRIPS.
• These stripped coupons do not pay periodic interest; their return is realized at maturity as the difference between their purchase price and face value.
• Investors use these instruments for precise cash flow matching, such as funding future liabilities or creating customized portfolios.
• The value of an Adjusted Free Coupon is highly sensitive to changes in interest rates due to its zero-coupon nature and deferred payment.

Formula and Calculation

An "Adjusted Free Coupon," once stripped, behaves like a zero-coupon bond. Its value is determined by discounting its single future face value back to the present using a relevant discount rate. The formula for valuing a single Adjusted Free Coupon (or any zero-coupon bond) is:

$PV = \frac{FV}{(1 + r)^n}$

Where:

• ( PV ) = Present Value (the price of the Adjusted Free Coupon today)
• ( FV ) = Face Value (the value of the individual coupon payment at its maturity date)
• ( r ) = Discount Rate (the market yield for a zero-coupon instrument with the same maturity, often equivalent to the yield to maturity)
• ( n ) = Number of periods until the coupon payment is received

This formula highlights that the present value of the Adjusted Free Coupon is inversely related to the discount rate: as rates rise, the present value falls, and vice versa.

Interpreting the Adjusted Free Coupon

Interpreting an "Adjusted Free Coupon" involves understanding its nature as a time-value-of-money instrument. Since it represents a single, future cash flow, its primary interpretation centers on its inherent discount and its sensitivity to interest rate movements. The deeper the discount from its face value, the higher the implied yield for that specific payment.

Investors interpret the price of an Adjusted Free Coupon as the present cost to secure a specific future lump sum. For example, if an investor needs $5,000 on a precise date ten years in the future, they can purchase an Adjusted Free Coupon (or a principal strip) that matures on that date with a face value of $5,000. The current price of this Adjusted Free Coupon reflects the market's prevailing discount rate for that specific maturity. The primary risk in holding an Adjusted Free Coupon, especially over long periods, is interest rate risk. As general market interest rates increase, the present value of the fixed future payment decreases, leading to a fall in the Adjusted Free Coupon's market price. Conversely, falling rates increase its value.⁵ This relationship is a fundamental aspect of all fixed income securities.

Hypothetical Example

Consider an investor, Sarah, who wants to save specifically for a tuition payment of $10,000 due in exactly five years. Instead of buying a traditional five-year bond with semi-annual coupons, she decides to purchase an "Adjusted Free Coupon" that represents a single $10,000 principal payment stripped from a longer-term Treasury bond, maturing in five years.

Let's assume the prevailing market yield for a five-year zero-coupon instrument is 3% per annum, compounded semi-annually.

To calculate the price Sarah would pay for this Adjusted Free Coupon:

1. Identify Face Value (FV): $10,000
2. Identify Annual Discount Rate (r_annual): 3% or 0.03
3. Identify Number of Years (Years): 5
4. Since it's compounded semi-annually, adjust the rate and periods:
   • ( r_{semi-annual} = 0.03 / 2 = 0.015 )
   • ( n = 5 \text{ years} \times 2 \text{ periods/year} = 10 \text{ periods} )

Using the formula:
$PV = \frac{10,000}{(1 + 0.015)^{10}}$
$PV = \frac{10,000}{(1.015)^{10}}$
$PV \approx \frac{10,000}{1.16054}$
$PV \approx \$8,616.50$

Sarah would pay approximately $8,616.50 today to receive $10,000 in five years. The difference of $1,383.50 between her purchase price and the $10,000 she receives at maturity is her return, which for tax purposes accrues over the holding period as interest income. This example illustrates how an Adjusted Free Coupon allows for precise future cash flow matching by isolating a single principal payment.

Practical Applications

Adjusted Free Coupons, in the form of Treasury STRIPS, have several practical applications in financial planning and portfolio management:

• Targeted Future Payments: Investors often use these instruments to meet specific future liabilities, such as college tuition payments, retirement expenses, or a down payment on a home. By purchasing a STRIP with a maturity date that aligns with the future liability, investors can lock in a specific future payout amount. This strategy is highlighted by resources like the Bogleheads community.
• Duration Management: For portfolio managers, STRIPS offer tools for fine-tuning a portfolio's duration. Because they are zero-coupon instruments, their duration is equal to their time to maturity, making them highly sensitive to interest rate changes. This allows managers to precisely adjust the overall interest rate sensitivity of their fixed income holdings.⁴
• Yield Curve Play: By investing in different maturities of STRIPS, investors can take positions on the future shape of the yield curve, speculating on how interest rates will evolve across different maturities.
• Zero-Coupon Bond Replication: While some corporate bonds are issued as zero-coupon bonds, government-backed STRIPS offer a default-risk-free alternative for investors seeking guaranteed single payments, useful for long-term strategies and minimizing credit risk.

Limitations and Criticisms

While providing distinct advantages, Adjusted Free Coupons (or stripped components) also come with limitations and criticisms:

• Interest Rate Sensitivity: Due to their zero-coupon nature, Adjusted Free Coupons are highly sensitive to changes in interest rates. A small increase in market rates can lead to a significant decrease in their market value, particularly for longer maturities. This is a critical risk highlighted by regulatory bodies. Investors holding these instruments until maturity avoid this price fluctuation risk, but those needing to sell on the secondary market before maturity may incur losses.
• Inflation Risk: The fixed nature of the future payment means that the real value of the Adjusted Free Coupon can be eroded by inflation, especially over long investment horizons. While Treasury Inflation-Protected Securities (TIPS) can be stripped into "TIPS STRIPS" that offer some inflation protection, standard Treasury STRIPS do not.
• Phantom Income (Tax Implications): A significant criticism, particularly for taxable accounts, is "phantom income." Although investors do not receive periodic cash payments from an Adjusted Free Coupon, they are generally required to report the accrued discount as taxable interest income each year, even if no cash has been received. This can create a tax liability without a corresponding cash inflow.³
• Complexity and Accessibility: While becoming more common, trading individual stripped components can be more complex than traditional coupon bonds. They are typically accessed through brokers and financial institutions rather than directly from the U.S. Treasury.²
• Market Microstructure Issues: Academic research suggests that the evaluation of fixed income strategies, including those involving stripped bonds, can be affected by market microstructure noise in transaction-based prices, potentially leading to misleading conclusions about abnormal returns.¹

Adjusted Free Coupon vs. Zero-Coupon Bond

The terms "Adjusted Free Coupon" and "Zero-coupon bond" are closely related but refer to different aspects of the same financial concept.

Essentially, an "Adjusted Free Coupon" can be considered a type of zero-coupon bond that specifically originated from the stripping of a coupon-paying bond's interest stream. While all Adjusted Free Coupons are zero-coupon instruments, not all zero-coupon bonds are "Adjusted Free Coupons" in the sense of being a stripped coupon; some are originally issued as zero-coupon bonds (e.g., Treasury bills).

FAQs

1. Are Adjusted Free Coupons the same as Treasury STRIPS?

An Adjusted Free Coupon is a conceptual term for a stripped interest payment, which is precisely what constitutes a significant part of Treasury STRIPS. Treasury STRIPS are specifically the individual interest and principal components of U.S. Treasury notes and bonds that are traded separately as zero-coupon securities. So, conceptually, an "Adjusted Free Coupon" closely aligns with a stripped interest component of a Treasury STRIP.

2. How do Adjusted Free Coupons generate returns?

Adjusted Free Coupons, like all zero-coupon bonds, do not pay periodic interest. Instead, they are purchased at a discount to their face value. The return is generated from the difference between the discounted purchase price and the full face value received at the maturity date of that specific coupon payment. This difference is considered interest income that accrues over the holding period.

3. Why would an investor choose an Adjusted Free Coupon over a traditional bond?

An investor might choose an Adjusted Free Coupon for highly specific financial planning needs. For example, if a precise amount of cash is needed on a particular future date, purchasing an Adjusted Free Coupon that matures on or around that date can provide a guaranteed lump sum. This allows for exact cash flow matching and eliminates reinvestment risk associated with traditional bonds' periodic coupon payments.

4. What are the tax implications of holding Adjusted Free Coupons?

For U.S. federal income tax purposes, investors holding Adjusted Free Coupons (STRIPS) are subject to "phantom income" or "imputed interest." This means they must report the prorated portion of the original issue discount (the difference between the purchase price and the face value) as taxable interest income each year, even though no cash payment is received until maturity. This makes them more suitable for tax-advantaged accounts.

5. Are Adjusted Free Coupons suitable for short-term investing?

Generally, Adjusted Free Coupons are not ideal for short-term investing. Their value is highly sensitive to changes in interest rates over shorter timeframes, leading to significant price volatility if sold before maturity. They are primarily used for long-term financial planning and cash flow matching due to their predictable lump-sum payment at a specific future date.