Things to know about US Treasury auctions

Treasury securities (T-bond / T-bill) are debt instruments issued by the federal government to raise money for government operating activities and to pay off maturing old loans. These securities are sold to institutional and individual investors through public auctions.

The results of these auctions have a strong impact on the bond market, showing the actual market demand for bonds. So how to read and understand the results of an auction?

Starting this week, Viet Hustler will start a new column: Basic Economic Knowledge every Saturday. The first article in the column will introduce readers to how US Treasury auctions are conducted.

Types of securities issued by the US Treasury

US Treasury securities have various maturities and different names:

• T-Bills: maturity shorter than 1 year

• Notes: shorter than 10 years

• Treasury bonds (Bonds) with maturity over 10 years

• Inflation-protected government securities (TIPS) and Floating Rate Notes (FRN) with various maturities

All securities >1 year can be called T-bonds, but those with maturity greater than 10 years cannot be called Notes.

FYI: The amount of T-bills and Notes has been trending strongly upward since last year.

• The reason is that long-term bond yields are too high => The Treasury does not want to lock in long-term loans (>10Y) at high interest rates, so temporarily refinance with short-term loans.

US Treasury auctions are "Dutch auctions", meaning all successful bidders pay the same price (receive the same yield), equal to the high yield (highest yield that the Government accepts to pay).

So how do US Treasury auctions take place?

What is a “Dutch auction”?

There are 2 types of bids:

• Non-competitive bid (non-competitive bid): individuals or small organizations agree to whatever the final bid price of the auction is.

• Competitive bid (competitive bid): bidders specify the interest rate they are willing to accept.

Example: The Treasury wants to raise 100 million USD in 10Y T-bonds with a target yield of 4%.

• The Treasury receives 10 million USD in non-competitive bids => The Treasury needs to raise an additional 90 million from competitive bids.

• Competitive bidders submit the following yields:

  • 25 million USD => at yield 3.88%

  • 20 million USD => yield 3.90%

  • 30 million USD => yield 4.0%

  • 30 million USD => yield 4.05%

  • 25 million USD => yield 4.12%

• Bids with the lowest prices (lowest yields) are accepted first and increasing until the auction raises the full 100 million USD.

  • Bidding can take place up to 30 days before the auction.

In the above example, the Treasury's acceptance process is as follows:

1. The 10 million USD non-competitive bid is accepted.

   => Still need to raise 90 million USD.

2. The Treasury accepts all bids up to 4.0% → raises 75 million USD → still short 15 million USD

3. Accepts 15 million USD at yield 4.05% (only half of the 4.05% bidders are accepted).

(This process is completely automated.)

Conclusion: all approved bidders receive the same yield (which is also the highest - high yield): 4.05%, even if they bid lower yields.

Quick way to evaluate US Treasury auction results

To evaluate whether an auction is successful or failed, or just as expected, there are 3 main factors to focus on

1. Highest accepted yield

2. Bidder structure

3. Bid-to-cover ratio

We need to compare the above data with the previous auction period of Treasury bonds with the same maturity, while also looking at the trend changes in the above data to gauge the state of market demand.

In this article, Việt Hustler will use the example of the results of the 7Y T-bond auction on 02/25/2021.

• This was a not very successful auction that caused bond prices to drop significantly and yields to surge on the free market.

  

(1) High yield: Highest accepted yield

Investors need to pay attention to whether high yield is higher or lower than the yield of bonds with the same maturity on the market at that time: bid/ask spread.

• High yield > market yield: this is an unattractive deal because the bond selling price in the auction session is even lower than on the market.

  => Bonds are considered “tailed” compared to the market

  • The higher the tail level, the more it indicates that the primary market (wholesales) demands higher yields than the secondary market (retail).

  • The recent 30Y T-bond auction had a record high tail level: this was a completely failed auction!

    

• High yield < market yield: the bond selling price in the session is higher, bonds are considered “traded through” compared to the market.

  • A positive sign showing that buyers are willing to accept yields lower than market yields (which are already low for government bonds under normal economic conditions).

However, this also needs to be placed in specific contexts.

• A traded through level higher than the previous auction is considered a positive sign.

(2) Bidder structure

Bidder structure indicates whether real demand or dealer demand is the main driver in the auction.

Auction participants buying Treasury bonds are divided into 3 types:

• Indirect bidders (Indirect bidder): are participants in the auction through intermediaries, usually foreign financial institutions that cannot buy directly.

  • Indirect allocation is often considered to represent demand for bonds from abroad and therefore a higher percentage allocation is considered positive.

• Direct bidders (Direct bidder): are financial institutions (not agencies) that place bids directly in the auction (not through intermediaries).

  This group typically includes pension funds, hedge funds, insurance companies, banks, governments, and individuals.

  => Direct and indirect bidders are considered accounts with “real demand” in the auction session.

• Primary Dealer (Designated primary dealer): are dealers designated to buy Treasury bonds in the primary market to resell in the secondary market (market maker in the secondary market).

  • Primary dealers are required to bid in auction sessions and use their own accounts.

  • A higher allocation ratio of bond sales to Primary Dealer may be a negative sign because real domestic and foreign demand has decreased (so the Treasury requires dealers to participate more strongly in the auction).

• For example, the auction on 02/25/2021:

  • bid amount and accepted amount for Indirect bidder were the same and quite low,

  • while Primary Dealer participated actively in bidding

  • => this indicates weak “real” demand in the auction session.

(3) Bid-to-cover ratio

Ratio Bid-to-cover = amount of bids placed / amount of bids accepted.

Bid-to-cover (BTC) the higher, the more successful the auction. In addition, accompanying criteria such as:

• A successful auction is one in which BTC exceeds the average of the previous 12 auctions for the same type of bond.

• Low BTC is considered a failed auction.

• The BTC ratio usually exceeds 2.0, especially for short-term securities.

• Some factors can influence a low BTC ratio, for example: Multiple new auctions at the same time => the amount of bonds bid for in one auction will decrease.

CONCLUSION

In conclusion, the general principle to evaluate the success of the auction session is through 3 factors

1. High yield spread compared to market yield (bid/ask spread)

   • High yield < market yield is a positive sign, and vice versa.

2. Structure of bidders

   • High bidding and acceptance ratios of indirect and direct bidders are considered positive (due to high real market demand)

3. Bid-to-cover ratio

   • Bid-to-cover (BTC) the higher, the more successful the auction.

At certain times, depending on market conditions, investors may need to pay attention to other details in the bond auction results announcement. However, these are the 3 core factors when evaluating US government bond auction results.