STRIPS are a kind of zero coupon bonds that are created by breaking apart regular treasuries. Instead of one regular bond, a number of new bonds are created. These new bonds are created in place of each of the expected payments on the original bond.
- There is a STRIP for each expected interest payment.
- There is a STRIP for the principal which will be redeemed at maturity.
STRIPs do not carry interest. Instead, they are sold at a discount with respect to their par value. An investor makes a profit on the difference between the price he pays and their par value.
The process of making STRIPs is called Coupon Stripping, and can only be done by certain financial institutions authorized to do so by the treasury.
Here is an example of stripping a treasury.
There is a treasury with ten years left until maturity. Interest is paid on the bond biannually, meaning that another twenty interest payments can be expected. Therefore, the bond can be converted into 21 STRIPS.
- One bond on the principal.
- 20 bonds, one for each expected interest payment.
American government bonds are sold off in Treasury Auctions.
Every year, there are approximately 150 treasury auctions. Most of the participants in these auctions are financial institutions and brokers who specialize in bonds. However, some private investors also take part. Ahead of each auction, the treasury announces exactly which kinds of bonds it will be selling, and how many will be offered.
There are two ways that bonds are auctioned: through noncompetitive and competitive bids.
1. Noncompetitive Bid
When buying bonds through a noncompetitive bid, each investor declares how many bonds he is interested in purchasing. Every investor is guaranteed to receive the number he requested, but the interest he will receive is unknown. The interest is determined by the competitive bids.
When purchasing bonds through a noncompetitive bid, there are limits to how much an investor can buy.
- T-Bills: One Million Dollars.
- T-Notes: Five Million Dollars.
The treasury figures out exactly how much was ordered through noncompetitive bids, and the remainder from the amount it wanted to sell is auctioned off to competitive bidders. Buying treasuries with a noncompetitive bid is most advantageous for private investors who want to save on broker fees.
2. Competitive Bid
In a competitive bid auction, each participant declares both the number of bonds he is interested in purchasing and the minimum interest that he is willing to receive. The treasury lists the bids it received in order from the least interest to the highest, and begins to sell bonds to those participants in that order.
Once all of the bonds have been sold, the interest listed on the bid of the participant who received the last bond is set as the interest rate for all the bonds, including those sold through noncompetitive bids. Participants who desired a higher interest rate will not be able to purchase any bonds.
Only large financial institutions that are designated Primary Dealers by the US government are allowed to participate in this auction. As of the beginning of 2006, there were 22 primary dealers:
- ABN AMRO Bank, N.V., New York Branch
- BNP Paribas Securities Corp.
- Banc of America Securities LLC
- Barclays Capital Inc.
- Bear, Stearns & Co., Inc.
- CIBC World Markets Corp.
- Citigroup Global Markets Inc.
- Countrywide Securities Corporation
- Credit Suisse Securities (USA) LLC
- Daiwa Securities America Inc.
- Deutsche Bank Securities Inc.
- Dresdner Kleinwort Wasserstein Securities LLC.
- Goldman, Sachs & Co.
- Greenwich Capital Markets, Inc.
- HSBC Securities (USA) Inc.
- J. P. Morgan Securities Inc.
- Lehman Brothers Inc.
- Merrill Lynch Government Securities Inc.
- Mizuho Securities USA Inc.
- Morgan Stanley & Co. Incorporated
- Nomura Securities International, Inc.
- UBS Securities LLC.
A private investor that wants to purchase government bonds with a noncompetitive bid needs to open an account at the treasury. This is called a TreasuryDirect account.