Question

As we discussed in class, the US Treasury bond rate is determined using an auction process. Thoroughly discuss how the bond auction process operates

Answer 1

Basically a bunch of different people (broker-dealers, institutions, individuals) participate in an auction for Treasury bills, notes, and bonds once every couple of weeks. Frequency depends on the specific instrument. Broker-dealers (think the GS, MS, and JPMs out there) use a software called FedTrade to bid in auctions.

If you bid competitively:

• You specify the amount/quantity of the bid, as well as the bid itself (e.g. bid $2bn at 5%, $2bn at 5.01%, $2bn at 5.015%, etc.) You bid in yield instead of price (remember yield is inversely correlated to price)
• You can bid for as many Treasuries as you want, but you will only get filled on 35% of the auction size (i.e. you can bid for the whole auction size if you want, but even if you win, you will only get 35%, the rest will go to the next highest bidder.
• All the bids from all the competitive bidders are aggregated, sorted by ascending yield AKA descending price. They then basically go down that stack until the amount of the auction is reached, then that price is the "stop-out" level for the auction, and everyone will be filled at that level. I.e. this is a dutch auction.

If you bid non-competitively:

• You are limited to getting $5mm notional in any auction
• You agree to accept the yield/price of the auction results.
• You are ahead of everyone who bids competitively in an auction in terms of getting your order filled.

Here's a concrete example of how the big banks might bid:

• Think about bidding for a bucket of 100 apples with a bunch of other people: if you think the "stop-out value" of an apple at this particular auction is 5 dollars (and that could be driven by a lot of different factors, supply/demand, where "off-the-run" apples are trading, where you think you'll be able to sell these new apples, etc), you might bid the following:

• 5 at 5.05
  10 at 5.00
  20 at 4.95

• You bid 5 at 5.05 to make sure you'll get filled at least for some. You bid 10 at the fair value. Then you bid 20 just in case the auction stops out more cheaply than you expect (i.e. the auction "tails"), at which point you want to scoop up some cheap apples.
• Say there are non-competitive bids that add up to 30 apples. Those orders will get filled regardless. The entire order stack look like this:

• A bids 10 at 5.10
  B bids 10 at 5.10
  A bids 20 at 5.05
  C bids 5 at 5.05
  D bids 35 at 5.025 -- stop out level reached since we hit 70
  B bids 10 at 5.01
  C bids 10 at 5.00
  C bids 20 at 4.95

• Auction Result: A gets 30, B gets 10, C gets 5, D only gets 25. Everyone gets to buy the apples at $5.025, including the non-competitive bidders.

• So this price ended up being a little bit higher than we originally thought, which means the demand for these apples was probably higher than we thought. We still got filled though, since we bid 5.05 as an insurance policy.
• Bid-to-cover ratio is 1.5 (150 competitive and non-competitive bids divided by the 100 apples up for auction), which is an indication of how much demand there was.
• Treasury auction works just like this, except instead of prices, you bid on the yield on the Treasury security. The "higher" the bid, the lower the yield you are willing to accept. And yes, in the past, there have been TIPS auctions where the stop-out level was a negative yield.