What it means
When a government spends more than it collects in taxes, it borrows by selling securities. Each sale is announced in advance, with the size, type, maturity and date, so that investors and dealers can plan their bids.
The schedule is published well ahead, which removes surprises and lets buyers arrange their cash. Offerings come in several forms.
Bills mature in a year or less and are sold at a discount, notes and bonds pay regular interest and mature over longer periods, and some securities adjust with inflation or with short-term rates. In an auction, investors submit bids and the Treasury accepts the lowest yields, or highest prices, until the amount offered is filled.
Every successful bidder in many auctions receives the same final yield, which encourages honest bidding. Bidders can be competitive, naming a yield, or non-competitive, agreeing to accept whatever yield the auction produces.
Primary dealers (large banks and brokers that deal directly with the central bank) are expected to bid in every auction, which helps to ensure that the sale succeeds. Other bidders include funds, pension schemes, foreign central banks and individuals.
Auction results are closely watched. A strong result, with demand well above the amount offered, shows investors are comfortable at current yields, while a weak result can push yields up and signal concern about debt levels or inflation.
For a business reader, an offering is a source of market information. The yields it produces feed into the cost of corporate loans, mortgage rates and the discount rates used in valuations.
In practice
Real-world examples.
Example
A money market fund bids at the weekly bill auction to invest cash that it needs back in three months. It submits a non-competitive bid and receives the yield set by the auction. The cash is paid on the settlement date, and the fund records the bill at its purchase price.
Example
A pension fund bids for a large block of long-term bonds to match its future payments to retirees. It bids competitively, naming the yield it requires. If the auction clears at a higher yield than its bid, the fund is filled in full at the better yield.
Example
A small business owner with spare cash uses a government website to buy a Treasury note at auction. She holds it until it matures and plans her cash flow around the interest payments. She sets a calendar reminder for the maturity date so the money can be reinvested promptly.
Formula
Calculation
For a Treasury bill sold at a discount, the price is:
Price = Face value x (1 - Discount rate x Days to maturity / 360)
Suppose an illustrative bill with a face value of $1,000,000 has 90 days left to maturity and is sold at a 4% discount rate. The price is $1,000,000 x (1 - 0.04 x 90 / 360) = $1,000,000 x (1 - 0.01) = $990,000. The investor receives $1,000,000 at maturity, so the interest earned is $1,000,000 - $990,000 = $10,000. The bid-to-cover ratio, which measures demand, is calculated as total bids divided by amount sold, so $90 billion of bids for a $30 billion offering is 3.0.Case study
Seen in the real world.
Greystone Mutual is an illustrative, fictional insurer with a large bond portfolio. The chief investment officer was planning to buy $200,000,000 of long-term government securities and had to decide whether to buy at auction or later in the market.
The team studied recent auctions and noted that the results had been strong, with bids more than twice the amount on offer. They placed a competitive bid for $120,000,000 at their target yield and bought the remaining $80,000,000 over the following weeks in the secondary market.
The auction filled most of the order at the desired yield with no need to chase the market. In this illustrative case, the approach avoided paying a premium that would have been required if all the purchases had been made after the auction. The chief investment officer reported the result to the investment committee along with the average yield achieved.
Watch out
Common mistakes.
- Assuming the yield at auction is the same as the quoted yield in the market, when they can differ by small amounts.
- Placing a competitive bid at too low a yield and ending up with nothing.
- Ignoring the settlement date, which is when the money is actually paid. Cash must be ready on that day, not on the day the bid is placed.
Questions
People also ask.
What is a competitive bid?
A competitive bid names the yield the investor requires and may be rejected if the yield is too low. Large institutions normally bid this way because they care about the price.
What is a non-competitive bid?
It agrees to accept whatever yield the auction sets and is almost always filled.
Why are auction results important?
They show how much demand exists for government debt and influence yields throughout the financial system. A weak auction can move bond prices within minutes of the result.
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