How US government bond auctions work and why they’re important to financial markets

• This guide outlines the key terms and players in US Treasury auctions
• It will help traders decipher whether demand for US debt is strengthening or weakening
• As a risk-free market instrument, Treasury performance is highly influential on asset classes further out the risk spectrum

Bond markets make the financial world go round, helping to grease the wheels of commerce, allowing economic activity to expand. But when too much debt is issued, it can overwhelm demand, causing borrowing costs to spike which can be detrimental to the economy.

This balancing act is attracting plenty of interest right now, especially when it comes to trends in government bond issuance which continues to increase rapidly in many advanced economies. With so much debt being issued at a time when activity is holding up and inflationary pressures remain firm, it’s leading to higher interest rates not only for governments but borrowers further out the risk spectrum.

Source: IMF

While bond yields tell you where the equilibrium between debt demand and supply intersect, for traders looking for an edge on when demand trends may be about to shift, you may want to keep an eye on debt auctions for clues. Because a sudden strengthening or weakening in demand for new debt can ripple quickly through secondary markets, impacting other asset classes.

To understand the dark arts of debt auctions, we’ve decided to produce a primer explaining the key players and terminology you need to be across. For this note, we’ll focus on US Treasury auctions given the US dollar’s role as the global reserve currency, making these events influential on borrowing costs in other nations.

Bond terminology 101

Before we get into auction specifics, let’s quickly recap the key bond terms every investor should know.

Face value: The amount the bond issuer agrees to repay at maturity

Market price: The market value of a bond

Coupon: Fixed interest rate paid to bondholders per annum, expressed as a percentage of the bond's face value

Yield: The effective interest rate an investor receives based on the bond's market value and coupon

Maturity: The date when the bond is repaid

Duration: A measure of a bond prices sensitivity to changes in interest rates

Primary market: When a bond is first issued at auction

Secondary market: When bonds are traded between market participants other than the issuer

US Treasuries issued

Treasuries are Treasuries, but when it comes to the date they mature, they are classified into different categories.

Bills: Treasuries with less than 12 months to maturity

Notes: Treasuries that mature within one to ten years

Bonds: Treasuries that mature beyond 10 years

Treasury auction terminology

Issuer: US Government

Bidders: Buyers (we’ll get to the different types in a moment)

Bid price: The price buyers are willing to pay

Bid quantity: The amount buyers want to purchase

Competitive bid: A buyer who specifies the price and amount of bonds they wish to purchase. Bids are submitted based on price

Non-competitive bid: A buyer who submits the amount of bonds they wish to purchase. The price is determined by the auction result

Yield: Interest the bond pays each year, expressed as a percentage of its current market price

Bid-to-cover Ratio: The ratio of total bids to total bonds on offer

Clearing price: The highest price the bonds being auctioned can be sold

Tail: Difference between the highest yield accepted and the yield expected prior to the auction

Stop-through: The bond is sold with a yield lower than what was indicated prior to the auction

Treasury auction buyers

Direct bidders: Usually large institutions such as banks, mutual funds, pension funds and insurers. Bids are submitted directly to Treasury. This group buys on behalf for their portfolios or on behalf of clients

Indirect bidders: Mostly foreign central banks, sovereign wealth funds and other foreign institutions. They submit non-competitive bids through a designated primary dealer (see below). Bids are submitted based on a set yield which is determined by the auction result

Primary dealers: Financial firms authorised to participate directly in auctions. They primarily act as intermediaries for indirect bidders and other clients. They are required to participate in auctions by submitting competitive bids via the New York Federal Reserve

Signs of a strong auction result

A high bid-to-cover ratio, a lower-than expected yield (stop-through) with a small or non-existent tail are signs of strong demand. In terms of successful bidders, higher allocations to non-direct and direct buyers excluding primary dealers are signs of healthy demand.

As you would expect,  opposite outcomes indicate weak demand. If studying auction results, the outcomes are graded relative to trends seen in prior auctions for debt of similar maturities.

Treasury’s Quarterly Refunding Announcement (QRA)

A statement outlining Treasury's plans for upcoming bond auctions. The announcements are usually released in February, May, August and November ahead of start of the new quarter.

The QRA includes information on auction dates, maturities and expected size of each security to be issued. Treasury may also offer guidance on longer-term borrowing requirements.

-- Written by David Scutt

Follow David on Twitter @scutty

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