treasury auctions: how bonds are sold

In short

I once watched a neighbor go to the county fair auction and bid on a quilt. She had no idea who else wanted it, so she waited, watched the room, and named a price she could live with. Treasury auctions work in a similar spirit, only the quilt is a government loan. The Treasury Department sells its bonds, notes, and bills at auction, which means buyers compete and the market sets the interest rate. If you are holding a Treasury security, it most likely came out of one of these sales. You can bid through TreasuryDirect, or through a bank or broker that bids for you. Bidders may choose a noncompetitive bid, which takes whatever rate the auction produces. That is a fair deal for the small saver.

The whole of it

What it is

A friend of mine once asked me why the government does not just print a price and be done with it. It is a fair question. The Treasury borrows money by selling securities, and it lets buyers decide what the rate should be. That way, no clerk in Washington has to guess what the market wants.

The securities come in a few kinds. Bills are short loans, the shortest running a few weeks and the longest up to a year. Notes run from two to ten years. Bonds are the longest loans, and the Treasury sells them in terms of twenty and thirty years. There are also inflation protected securities, called TIPS, and floating rate notes. Each kind is sold the same basic way, by auction, on a published schedule.

You have probably heard that Treasury debt is safe. What that means is that the lender is the United States government, and the borrower has to repay what it promised. The price can still rise and fall if you sell before maturity. That is a separate matter from the promise to repay.

How it works

If you are curious how the sale actually goes, picture a quiet room, only the room is a computer system. The Treasury announces an auction ahead of time. The notice says what is for sale, how much, and when. Buyers then submit bids before the deadline.

There are two kinds of bids. A competitive bid names the rate or yield the buyer will accept. A noncompetitive bid names only the amount, and the buyer agrees to take the rate the auction sets. The Treasury serves the noncompetitive bids first, up to the limit it sets for them. Then it sorts the competitive bids from the lowest rate to the highest.

Here is the part that surprised me. The Treasury uses a single price format. Everyone who wins pays the same price and earns the same rate, no matter what they bid. The Treasury fills the offering starting with the lowest rates, and it stops when it has sold the whole amount. The highest rate it has to accept to sell everything is called the stop out rate. Every winner gets that rate.

That is a kind thing for a first time bidder. You do not need to outguess the room. A noncompetitive bidder simply receives the same result as the winning competitive bidders.

Large banks and dealers bid in big blocks, and many of them are required to bid by their role in the market. Individuals can bid in small amounts at TreasuryDirect, the Treasury's own website, where the minimum purchase is the current figure, which the official source publishes each year.

The numbers, and where to find yours

I remember sitting with an old farmer who kept his figures in a shoe box. He said a number you cannot find is no help to anyone. So here is where to look.

The minimum purchase at TreasuryDirect is set by the Treasury, and the current figure is the current figure, which the official source publishes each year. The most a person may buy in a single noncompetitive bid is the current figure, which the official source publishes each year. These can change, so check the date on the figure the page shows you.

The auction schedule, results, and the stop out rates are posted on the TreasuryDirect website and on the Bureau of the Fiscal Service pages. The Treasury Department runs the auctions, and the Bureau of the Fiscal Service handles the details. If you want to know what rate the last auction produced, the results page will tell you.

Your own numbers are simpler. Look at the amount you want to lend, the term you choose, and the rate the auction sets. Those three things decide what you earn.

A worked example

Let me tell you about a woman named Dolores. She is a retired schoolteacher with $5,000 she does not need for a year. She wants a safe place to park it.

Dolores opens a TreasuryDirect account and picks a 26 week bill. She enters a noncompetitive bid for $5,000. She does not name a rate. She trusts the auction to set one.

The auction runs. Say the stop out rate comes in at a discount rate of 4 percent. Bills are sold at a discount, which means a price below face value, and the buyer receives the full face value at the end. The Treasury pays no regular interest on a bill. The gain is the gap between what Dolores paid and what she gets back.

Here is the math, simplified. A 26 week bill lasts 182 days. The discount is the face value times the rate times the days, divided by 360. That is $5,000 times 0.04 times 182 divided by 360. Working it through, $5,000 times 0.04 is $200. Then $200 times 182 is $36,400. Then $36,400 divided by 360 is about $101.11.

So Dolores pays about $5,000 minus $101.11, which is $4,898.89. When the bill matures, the Treasury pays her $5,000. Her gain is the $101.11 gap.

Notice what she did not have to do. She did not have to guess the rate. She did not have to compete with a big bank. She named an amount and took the result. A simple plan, and a decent one.

Where it goes wrong

I have made my share of mistakes with money, and most came from hurrying. A few things trip people up here.

The first is the difference between the discount rate and the actual yield. The discount rate uses a 360 day year and the face value as its base. The true return on the money paid is a bit higher. If the two numbers look different, that is why. The auction results page shows both.

The second is selling early. A Treasury note held to maturity pays its promised amount. A note sold before maturity sells at the market price that day. If rates have risen, the price may be lower than what the seller paid. The seller bears that risk, and the Treasury does not make it up.

The third is timing. A noncompetitive bid has to be in before the auction deadline. A late bid misses the sale. Then the buyer must wait for the next one.

The fourth is the account itself. TreasuryDirect requires a bank account link and some patience to set up. A person who waits until the day before an auction may find the account is not ready. Open it early.

The fifth is a plain one. Rate is not the only thing that matters. A shorter term gives less rate risk but means more frequent reinvesting. A longer term locks in a rate but ties up money. Neither is wrong. They are different tools.

Questions to answer before you leave this page

Do you know how long you can leave this money untouched, and does the term you are considering fit that? Have you opened a TreasuryDirect account, or will you use a bank or broker, and do you know what that route costs? Are you comfortable taking whatever rate the auction sets, as a noncompetitive bidder does, or do you want to name your own? Have you checked the auction schedule so you know the deadline for the next sale? Do you understand the difference between the discount rate and the yield, and which one the results page is showing you? If you sold before maturity, could you live with a price lower than what you paid? And have you looked at the Treasury's own pages for the current minimums and limits, rather than trusting a number you heard secondhand?