Treasury auctions

U.S. government securities are first sold to investors through Treasury auctions. You can buy new-issue Treasuries either through the government’s platform (TreasuryDirect) or through a broker-dealer. As with any auction, buyers submit bids. Two types exist:

• Competitive bids
• Non-competitive bids

Competitive bids are usually submitted by large financial institutions that buy significant amounts of Treasury securities for customers or for their own portfolios. These bids are “competitive” because awards go to the best offers. A competitive bidder states:

• The amount they want to buy, and
• The lowest yield they’re willing to accept (sometimes called the discount margin rate)

For example, a bank might bid for $5 million of Treasury bills at a yield of 4%. We’ll walk through how the bidding works next.

Non-competitive bids are usually submitted by retail investors. The maximum allowable bid is $10 million. Non-competitive bidders are guaranteed to receive the amount they bid for, and they receive the yield determined by the competitive auction.

Definitions

Retail investor

An individual personally investing for themselves, family members, or other related parties (a non-professional investor)

Institutional investor

A single entity investing on behalf of others as a business activity (a professional investor)

Examples: investment advisers, investment companies, hedge funds

To see the mechanics, assume the Treasury offers $50 million of Treasury bonds and receives $20 million of non-competitive bids. That leaves $30 million to be awarded to competitive bidders. These competitive bids come in:

• $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 (the issuer wants to pay the lowest acceptable return). With $30 million available for competitive awards:

• Institution #3 bids the lowest yield (5.25%) and receives the full $10 million requested.
  • Remaining to award: $20 million
• Institution #1 has the next lowest yield (5.50%) and receives the full $7 million requested.
  • Remaining to award: $13 million
• Institution #2 has the next lowest yield (6.25%) and receives the full $5 million requested.
  • Remaining to award: $8 million
• Institution #4 is next (6.50%) but only receives $8 million of the $10 million requested.
  • Remaining to award: $0

Because Institution #4 is the last winning bid, its yield (6.50%) becomes the yield assigned to:

• All non-competitive bidders, and
• All winning competitive bidders (even those who originally bid lower yields)

In other words, the “highest of the lowest” winning yields sets the yield for the entire offering. Real auctions have additional details, but this example captures the core idea.

OTC trading

After the auction, U.S. government securities trade in the over-the-counter (OTC) markets. As you saw in an earlier chapter, an OTC trade doesn’t occur on a physical exchange like the New York Stock Exchange. Instead, investors buy and sell through networks of dealers, brokers, and financial institutions.

Like most securities today, Treasury securities are issued in book entry form, so there’s no physical certificate.

Quotes

Like corporate bonds, U.S. government debt is typically quoted in percentage of par. The key difference is the fraction:

• Corporate bonds are often quoted in eighths.
• U.S. government securities are quoted in 32nds.

The Treasury market is extremely large and active, so quoting in 32nds allows for finer price differences.

Treasury quotes may look different, but converting them to a dollar price works the same way as with corporate bonds.

An investor finds three separate quotes for the same bond:

• 95-8
• 95:8
• 95.8

Treasury quotes can use a dash, colon, or period. In all cases, the number to the right is assumed to be in 32nds, so each quote means:

• 95 and $\frac{\text{8}}{\text{32}}$ percent of par

Unlike corporate bond quotes, you don’t reduce the fraction.

If you use the same “fraction-boot-scoot” method we used with corporate bonds, you can convert the quote to a price. The only difference is that the fraction is in 32nds.

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 corporate bond quotes. The quotes look different, but both corporate and U.S. government securities are quoted in percentage of par.

Sidenote

Bid & ask with bond quotes

From time to time, you may see a bond quote like:

97-8 x 97-12

This is a bid-ask quote. Dealers buy and sell securities (including U.S. government securities) to earn a profit, similar to how a used car dealer buys at a lower price and sells at a higher price.

This quote shows both dealer prices:

• The left side (97-8) is the bid, the price the dealer is willing to pay.

  • If the dealer is buying, the customer is selling.
  • So an investor can sell the bond to the dealer at 97-8 ($972.50 assuming $1,000 par).

• The right side (97-12) is the ask (or offer), the price the dealer is willing to sell at.

  • If the dealer is selling, the customer is buying.
  • So an investor can buy the bond from the dealer at 97-12 ($973.75 assuming $1,000 par).

The difference between the bid and ask is the spread. It represents the dealer’s potential profit if they buy from one customer and sell to another at the same time. In this example, the spread is $1.25 per $1,000 par bond ($972.50 vs. $973.75).

Treasury bill quotes are an exception. Because T-bills are short-term, zero-coupon securities, they’re quoted in discount yield form, which reflects the rate of return the bill provides. The same idea applies to similar securities like commercial paper.

For example, a Treasury bill quote might be 3.2%. This quote is a yield, not a price. Remember:

• Treasury bills are purchased at a discount and mature at par.
• The yield reflects the overall return based on the purchase price compared to the redemption value.

T-bill bid-ask quotes may also look different. For example:

3.2 x 3.1

Most bid-ask quotes show the smaller number on the left (bid) and the larger number on the right (ask). T-bill bid-asks can look reversed, but the meaning is the same:

• Bid = dealer’s buy yield (customer’s sell yield)
• Ask = dealer’s sell yield (customer’s buy yield)

The key is that T-bills are quoted in yields, and yields move inversely to prices:

• Higher yield → lower price
• Lower yield → higher price

So a yield of 3.2% corresponds to a lower-priced T-bill than a yield of 3.1%. A yield of 3.1% corresponds to a higher-priced T-bill than a yield of 3.2%.

Bottom line: if a bid-ask looks “backward” (higher number on the left, lower number on the right), it’s usually because the quote is yield-based. Treasury bills are the most common example.