The market

Treasury auctions

U.S. government securities are initially offered to investors through Treasury auctions. Investors can purchase securities directly through the government’s sponsored platform (TreasuryDirect) or their broker-dealer. Like any other auction, potential buyers must submit bids. Two types exist:

• Competitive bids
• Non-competitive bids

Competitive bids are typically placed by large financial institutions buying significant amounts of Treasury securities for their customers or portfolios. As the name suggests, this bid awards Treasury securities to the most competitive offers. Institutions placing bids declare the amount they’re attempting to purchase with the lowest yield they’ll accept (sometimes called the discount margin rate). For example, a bank submits a bid for $5 million in Treasury bills with a yield of 4%. We’ll discuss the bid process below.

Non-competitive bids are usually placed by small retail investors purchasing Treasury securities for their portfolios. The maximum allowable bid is $10 million. Non-competitive bidders are always granted the amount they bid on and are awarded a yield the competitive bidders determine.

To better understand the dynamics of a Treasury auction, let’s assume the following - the Treasury offers $50 million in Treasury bonds, and $20 million of non-competitive bids are submitted. The remaining $30 million is left to be bought up by the competitive bidders. These are the competitive bids received:

• $7 million at 5.50% yield from Institution #1
• $5 million at 6.25% yield from Institution #2
• $10 million at 5.25% yield from Institution #3
• $10 million at 6.50% yield from Institution #4
• $8 million at 6.75% yield from Institution #5

The Treasury accepts the lowest yields first - remember, issuers always want to pay the least acceptable return to investors. With $30 million to be awarded, Institution #3 has the lowest bid yield and is granted the $10 million requested. Now $20 million remains left to be awarded. Institution #1 has the second lowest bid yield and will be granted the $7 million requested. Now $13 million remains left to be awarded. Institution #2 has the next lowest bid yield and will be granted the $5 million requested. Now $8 million remains left to be awarded. Institution #4 has the next lowest bid yield and will be granted only $8 million of the $10 million requested.

As the last winning bid, Institution #4’s bid yield of 6.50% is assigned to all non-competitive bidders and winning competitive bidders (including those who bid lower yields initially). Essentially, the “highest of the lowest” sets the yield for the entire offering. Although it’s more complex in the real world, this example depicts how a Treasury auction works.

OTC trading

After the auction concludes, U.S. government securities trade exclusively in the over-the-counter (OTC) markets. If you recall from an earlier chapter, an OTC trade does not take place on a physical exchange like the New York Stock Exchange. Essentially, investors buy and sell these investments through networks of dealers, brokers, and financial institutions. Like most securities available today, Treasury securities are issued in book entry format with no physical certificate.

Quotes

Similar to corporate bonds, U.S. government debt is typically quoted in percentage of par format. Instead of quotations in eighths, U.S. government securities are quoted in 32nds. The change in quotation style is due to the size and level of activity in the Treasury market (which is enormous). When a bond can be quoted in 32nds (as opposed to eighths), there are more possible trading prices.

U.S. government debt quotes look different, but converting to a price is the same as corporate bonds.

An investor finds three separate quotes for the same bond:

• 95-8
• 95:8
• 95.8

U.S. government quotes can appear with a dash, colon, or period. Although you don’t see a fraction above, the quote translates to a bond price of 95 and $\frac{\text{8}}{\text{32}}$ percent of par. The number on the right (after the dash, colon, or period) is always assumed to be in 32nds. Unlike corporate bonds, there is no reduction of the fraction.

If you utilize the same “fraction-boot-scoot” method we used with corporate bonds, you can convert the quote to a price. The only difference is the presentation of the fraction. Let’s look at a few examples.

A US Government bond is quoted at 95-8. What is its price?

Step 1: calculate the fraction

• $\frac{\text{8}}{\text{32}}$ = 0.25

Step 2: boot the decimal back to the big number

• 95 + 0.25 = 95.25

Step 3: scoot the decimal once over to the right

• $952.50

Think you can do it on your own? Give it a try!

A US Government bond is quoted at 103:20. What is its price?

As you can see, the process is very similar to how we approach corporate bond quotes. The quotes look and feel different, but the method is the same. Both corporate and U.S. Government securities are quoted in percentage of par format.

Treasury bill quotes are an exception to this process. Due to their short-term zero-coupon nature, their quotes exist in “discount yield” form, reflecting the rate of return the bill provides. The same applies to similar securities like commercial paper.

For example, a Treasury bill quote might look like 3.2%. Instead of providing an actual price, the investor knows they will achieve an overall return (yield) of 3.2%. Remember, Treasury bills are bought at discounts and mature at par. The yield represents the overall rate of return achieved when comparing the purchase price to the redemption value. Additionally, T-bill bid-asks may look slightly different than we initially discussed above. For example:

3.2 x 3.1

Most bid-asks show the small number on the left (bid) and the big number on the right (ask). T-bill bid-asks look the opposite, although the bid still represents the dealer’s buy price (customer’s sell price), and the ask still represents the dealer’s sell price (customer’s buy price). Remember - Treasury bills are quoted in yield form, not with prices. Yields are inversely related to prices - the lower the yield, the higher the price, and vice versa.

Therefore, a yield of 3.2% will represent a lower-priced T-bill than one with a yield of 3.1%. The higher the yield, the lower the price of the Treasury bill. On the other hand, a yield of 3.1% will represent a higher-priced T-bill than one with a yield of 3.2%. The lower the yield, the higher the price of the Treasury bill.

Bottom line - if you encounter what seems to be a “backward” bid-ask spread (the lower number on the right and the higher number on the left), it’s a reference to a yield-based bid-ask quote. T-bills are the most common security quoted this way!