How do treasury auctions work?

The US government decides it needs to borrow money. How does it do so? This article will attempt to explain how US treasury auctions work.

First, the US government will issue a notice indicating how much money it would like to borrow. Below is an actual announcement issued by the treasury department that it will be having an auction to raise $23 billion.

The length of the borrowing for this particular auction is 1 year. That means you give the government some money and 1 year later the government will give you back your money and a little extra. The difference between what you paid and what you receive back is the yield, which is usually expressed as a percentage. For example, if you gave the government $90 and at the end of the year they gave you back $100 then your bond yielded 11% = (100-90)/90 * 100. Interest payments would also figure into the yield for treasuries that emit interest.

The differences between the different types of treasuries:

Treasury Bill - short term ranging from a few days to 52 weeks. No interest is paid on these.

Treasury Note - term length of 2, 3, 5, 7, or 10 years. Interest is paid every 6 months to the holder of the note.

Treasury Bond - term length of 30 years. Interest is paid every 6 months to the holder of the note.

The announcement indicates the date of the auction (March 8th, 2011 in the example) as well as deadlines for competitive (11:30 AM) and noncompetitive (11:00 AM) bids. If you would like to participate in the auction then your bids must be submitted before these times.

Competitive Bid - the bidder specifies the maximum price they will pay for the security. All treasuries are priced in $100 so bids are submitted in terms of buying a security that will repay the owner $100 when the security matures ($100 is the face or par value).

Noncompetitive Bid - the bidder does not specify any maximum price requirement. These bidders are first in line to be issued a bill but they will get whatever price is determined at auction.

There is a limit of $5 million that can be submitted as a noncompetitive bid per bidder per auction.

For competitive bids any one customer can be awarded a maximum of 35% of the total offering.

In order to better illustrate the mechanics of the auction let's go back to the example. The table below is a hypothetical list of bids for the $23 billion being issued. The bids include the total amount the bidder is willing to purchase as well as the maximum price the bidder will pay based on a $100 par value note.

Bid 1: $5 billion, max price: don't care (noncompete)
Bid 2: $10 billion, max price: don't care (noncompete)
Bid 3: $5 billion, max price: $98
Bid 4: $5 billion, max price: $95
Bid 5: $10 billion, max price: $92
Bid 6: $5 billion, max price: $90

Notice there is a total of $40 billion in bids. The auction is only for $23 billion. This means some bids will go unfilled. The ratio between bids and the amount of the auction is called the bid-to-cover ratio. For our example it is 1.74 ($40/$23). A high bid-to-cover ratio indicates a strong demand for the bonds since there are a lot of bidders. A low ratio indicates weak demand. A ratio under 2.0 is considered weak.

The bids are filled in the following manner:
  1. All the noncompetitive bids are filled first. This means Bid 1 and Bid 2 will be filled first. This fills $15 of the $23 billion leaving $8 billion left.
  2. Once all the noncompetitive bids are filled then the competitive bids are filled next starting from the highest max price and proceeding to the lowest until the issue is completely fulfilled. This means Bid 3 will be filled in full. The remaining $3 billion will be issued to Bid 4. For this auction Bid 5 and Bid 6 will go unfilled.
  3. Since Bid 4 was the last accepted competitive bid, its max price will be the price that all (both competitive and noncompetitive) bidders will receive. This price will also determine the yield for this auction which is 5.26% (100-95/95 * 100).
Results of our example auction:

Bid 1: $5 billion, max price: noncompetitive, All $5 billion filled at $95
Bid 2: $10 billion, max price: noncompetitive, All $10 billion filled at $95
Bid 3: $5 billion, max price: $98, All $5 billion filled at $95
Bid 4: $5 billion, max price: $95, Only $3 billion filled at $95
Bid 5: $10 billion, max price: $92, Not filled
Bid 6: $5 billion, max price: $90, Not filled

Once the auction is completed the treasury will post the results of the auction. Below is the actual results of the auction.

There are some additional items that are reported from the auction:
High Rate: This is the highest yield (or the lowest price) that was accepted at the auction. For our example this would be $95.
Allotted at High: This is the percentage of the total that was filled at the highest accepted yield (or lowest accepted price). For our example, the last $3 billion we filled was at the lowest price so our allotment at high would be $3/$23 = 13%.
Price: Price as determined by the auction.
Median Rate: Half of the competitive bids were submitted below this rate while the other half were above.
Low Rate: The lowest yield (or highest price) submitted for the competitive bids.

The announcement also shows the breakdown of the amount of bids submitted noncompetitively versus competitively and how much was rewarded for those same categories.

An additional item is provided in the results announcement: a breakdown into three categories of who submitted, and was awarded, the competitive bids. The three categories:

Primary Dealers: A primary dealer is a bank that works with the FED to purchase government securities. A bank identified as a primary dealer is required to bid on US treasuries. In this way US treasury auctions are designed to never fail. Primary dealers must always fill in if there are no other bidders.
Direct Bidders: These are bidders who submitted bids directly. These can be individual investors, banks, or money managers. This usually represents domestic demand.
Indirect Bidders: These are bidders that bid on behalf of others. This is thought to represent foreign central banks and governments. This usually represent foreign demand of US treasuries.

There is an entry in the middle of the results announcement listed as SOMA. This stands for System Open Market Account. This represents treasuries that are held by the Federal Reserve. If the Federal Reserve has treasuries that are maturing then it is expected that they will use the proceeds from those maturing treasuries to buy new treasuries. For our example auction the FED had no bills maturing at the time. If they did then the FED would also get the same price determined at the auction. Below is the results from a different auction where the FED rolled over the holdings into new treasuries.


Sources: here, here, and here

14 comments:

  1. Hi. Nice write up. Question: how does the $3B get distributed among Bid #4, which has $5B of total bids?

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  2. Good question. My hypothetical example assumed each bidder was one party or individual. If multiple people submitted the exact same bid I'm not sure how the Treasury resolves this - maybe by who submitted their bid first. That is just a guess.

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  3. Just to enhance on your example i.e. defining how 35 percent for Competitive Bidding:
    Suppose the following is the scenario:
    1: Bid 1: $5 billion, max price: don't care
    2: Bid 2: $5 billion, max price: don't care - Take a note of the new quantity i.e. $5 billion
    3: Bid 3: $15 billion, max price: $98 - Take a note of the new quantity i.e. $15 billion
    4: Bid 4: $5 billion, max price: $95
    5: Bid 5: $10 billion, max price: $92
    6: Bid 6: $5 billion, max price: $90
    The bids are filled in the following manner:
    1. All the noncompetitive bids are filled first. This means Bid 1 and Bid 2 will be filled first. This fills $10 of the $23 billion leaving $13 billion left.
    2. Once all the noncompetitive bids are filled then the competitive bids are filled next starting from the highest max price and proceeding to the lowest until the issue is completely fulfilled.
    1. Remaining is $13billion but Bid 3 is of $15 billion, max price: $98. Logically the bid should stop here i.e. the final discount value is $98. Therefore Bid 1 and Bid 2 get fulfilled in full at $98
    2. Seems Bid 3 should have got the remaining $13 billion at $98, but here is the catch. Maximum percentage for a competitive bid is 35 percent of total offering i.e. in this case it is 23 X 35\100 = $8.05 billion.
    3. Therefore Bid 3 shall only get $8.05 billion out of $13 billion. The remaining $4.95 billion goes to Bid 4.

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    Replies
    1. Does that mean the final price will be at $95?

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  4. @saurabh: Good catch. My article documents this limit but I failed to account for it in my example. I'll update the article to reflect this limit.

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  5. The system goes in my opinion against the US treasury. The non competitive bidders should receive the bills at the highest price offered, i.e. 98% or at least an average of the higest prices.... and the treasury will get more money for their bills

    Carlos Schaefer

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  6. This was a great article! It explains everything very well and is well written. Thanks!

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  7. It seems strange that the non-competitive bids get filled first. What is then the advantage in submitting a competitive bid? And if no-one submits a competitive bid, then what? How does the price get set?

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  8. This comment has been removed by the author.

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  9. A competitive bidder isn't forced to pay more than they value the bills. Consider bid 6: That bidder was only willing to buy bills if they were $90, so they lost the auction.

    I would imagine non-competitive bidders would be bidders who are not price sensitive (e.g., who are managing accounts for people who will buy any T-Bill that is below par).

    As for no-one submitting a competitive bid, the system is designed to prevent that from happening in two ways: 1) Primary dealers are required to bid. 2) Capitalism discourages this. If a bank conceived of this possibility, they'd offer a competitive bid of $50 and earn a 100% ROI (unless some other bank offered $80 and earned a 25% ROI, which is steal gigantic for a 1 year TBill).

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  10. Why are there two separate noncompetitive bids?

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    Replies
    1. Because there are two separate entities submitting noncompetitive bids.

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  11. This comment has been removed by the author.

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  12. Hi Ed,
    Thanks for your insights.
    Just wondering, what the cutoff time is, for the bid to be received, to be eligible to participate in the treasury auction.
    Thank you for the article. Very much.

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