how Treasury auctions work and how to buy Treasuries directly

In short

A friend of mine once asked why anyone would buy a government bond from a bank when the government sells them straight to the public. I had no good answer, and I think you may be in the same spot. The Treasury sells its bills, notes, and bonds at auctions, and an ordinary person can bid in them through a free account at TreasuryDirect. A small buyer does not pick a price. The buyer places a noncompetitive bid, which means the buyer accepts whatever rate the auction sets. The Treasury sets a floor on the smallest purchase and a ceiling on how much one person can bid in a single auction, so check both on the official page. Treasury bills pay no interest along the way, so you get a discount up front and the full face value at the end. Notes and bonds pay interest twice a year. Go in knowing the rules, and the process turns out to be plainer than it looks.

The whole of it

What it is

I once watched an old farmer count the cost of a loan he made to his neighbor, a handshake and a promise to repay by harvest. A Treasury security is much the same thing, only the borrower is the United States government. If you are holding cash you do not need for a while, you can lend it to the Treasury. In return, the Treasury promises to pay you back on a set date, and in most cases to pay you interest as well.

There are several kinds. A Treasury bill matures in one year or less. A Treasury note matures in two to ten years. A Treasury bond is the longest kind, and the Treasury currently sells bonds that mature in twenty years and in thirty years. There are also Treasury inflation protected securities, called TIPS, whose principal rises and falls with the consumer price index, and floating rate notes, whose rate moves with short term bill auctions. The Treasury describes all of these on its TreasuryDirect site.

The word auction may sound grand, but it is only a way of letting the market set the price. The Treasury announces how much it plans to sell. Buyers then bid. The result tells everyone what rate the government must pay to borrow that day.

How it works

A neighbor of mine once said the secret to a good auction is knowing who else is in the room. At a Treasury auction, the big players are banks, funds, and dealers. They place competitive bids, naming the rate they will accept. A small buyer in the same room places a noncompetitive bid and accepts the single rate the auction sets for everyone.

Here is the order of events. The Treasury announces the auction ahead of time, listing the amount for sale and the date. Bids come in. The Treasury sorts the competitive bids from the lowest rate to the highest. It fills those first, then fills the noncompetitive bids in full, up to the stated limits. It keeps accepting higher rates until it has raised the amount it wanted. The highest rate it accepts becomes the one that sets the price for everyone, noncompetitive buyers included. This is called a single price auction.

Bills are sold at a discount. The buyer pays less than face value and receives the full face value at maturity. The gap is the interest. Notes and bonds are sold at or near face value and pay a fixed rate twice a year until they mature. The Treasury says the rate on a note or bond is set at the auction and stays the same for life.

To buy directly, the buyer opens a TreasuryDirect account, links a bank account, and enters a bid before the auction closes. Payment is taken from the linked account on the issue date. The Treasury lists the schedule of upcoming auctions on its site, and it explains the bidding steps there too.

One more path is worth knowing. A buyer can also buy through a broker, who sells Treasuries on a secondary market, where older securities trade between investors. That route can offer more choice about timing, though it may carry fees that TreasuryDirect does not charge.

The numbers, and where to find yours

I am a plain man, and I like a number I can check. A few figures here are set by the Treasury or by law, and they can change. The smallest amount a buyer can purchase is the current figure, which the official source publishes each year, and the Treasury sets that figure on its TreasuryDirect pages. The limit on a single noncompetitive bid is the current figure, which the official source publishes each year, and you should read the current figure and its date on the official page before you bid. The tax treatment is also set by law. Interest from Treasuries is subject to federal income tax and is exempt from state and local income tax, according to the Treasury and the Internal Revenue Service.

Your own numbers are simpler. They are the amount you can lend without needing it back soon, and the date you will want it returned. Those two facts help you pick between a bill that matures in weeks and a note that matures in years. Match the date to your need. Nothing more.

You can find the latest auction results and the schedule on the Treasury's TreasuryDirect site, run by the Bureau of the Fiscal Service. That is the primary source, and it is the one to trust over any summary, mine included.

A worked example

Let me tell you about a woman I will call Margaret. She is a teacher who had saved $5,000 for a roof repair she expected to need in about six months. She did not want it sitting still, and she did not want to risk it.

Margaret opened a TreasuryDirect account and looked at the schedule. She chose a 26 week bill, which is a six month bill. She placed a noncompetitive bid for $5,000 in face value. Suppose the auction set a discount rate that made the price of each $100 of face value equal to $98. Her cost is found like this: $5,000 of face value times $98 per $100 is $4,900. She pays $4,900 on the issue date.

At maturity, the Treasury pays her the full $5,000. Her interest is $5,000 minus $4,900, which is $100. On a purchase of $4,900, a $100 gain over six months is about 2.04 percent for the period, since $100 divided by $4,900 is 0.0204. These are plain figures made up for the story, not a forecast, and a real auction will set its own price.

The money came back right when the roof needed it. Margaret told me she liked that the date was fixed. She knew when the cash would return, and she knew the amount.

Where it goes wrong

I have made my share of mistakes, and I would rather tell you about the common ones than pretend nobody trips. The first is timing. A bid placed after the auction closes will not count, so the buyer has to enter it before the deadline. A buyer should read the cutoff on the official page.

The second is the lock on the money. If a buyer needs cash before a note or bond matures, the buyer may sell it, but the price then depends on the market that day. Rates may have risen since the purchase, and an older security can sell for less than its cost. A buyer who holds to maturity gets the face value back, though a buyer who sells early may not.

The third is the surprise at tax time. Interest is taxable at the federal level, and the buyer has to report it. The Internal Revenue Service describes how in its guidance on interest income. Many people forget that a bill's discount counts as interest, too.

A fourth trouble is the funding link. The plan requires the linked bank account to hold enough money on the issue date. If it does not, the purchase may fail. Check the balance first.

Last, there is the temptation to chase a rate. A noncompetitive bid takes the result, whatever it is. A buyer who wants a certain rate has to bid competitively, and that carries the risk of getting nothing if the bid is too low. Think about which matters more to you.

Questions to answer before you leave this page

How much money can you set aside without needing it back for a while, and what day will you want it returned? Would a bill, a note, or a bond fit that date best? Are you willing to accept whatever rate the auction sets, or would you rather name your own and risk missing out? Have you looked at the current minimum purchase, the current bid limit, and the auction schedule on the official TreasuryDirect site? Will the linked bank account hold enough money on the day payment is taken? And have you thought about how the interest will be taxed, so there is no surprise next spring?