President Obama’s 2013 Budget is proposing another huge deficit in the area of $1.3 trillion. And that’s for the next fiscal year. 2012 is locked in stone and the deficit will be about this big this year. All of this budget shortfall has to be borrowed and the U.S. Treasury will be busy raising this money in the open market. The Treasury will be selling bills, notes and bonds in the market almost every day again this year.
In that context I wanted to offer a brief review of the Treasury auction process. I will review the general auction process, provide information on how to measure the success of a given auction and try to assess what the impact might be on the direction of interest rates in 2012.
The auction process
The vast majority of debt sold by the Treasury comes in the form of auctions. The Treasury announces the terms of a given sale, opens the auction for bidding, and awards the paper based on the cheapest price (lowest yield to the Treasury) produced by the entirety of the bids received.
The Treasury regularly auctions 4-week, 3-month, 6-month and 1-year bills. These shorter-dated maturities are sold at a discount, carry no coupon and mature at par. The Treasury prefers to use the discount price method as opposed to having the securities carry a coupon because that’s how the majority of cash substitute instruments are priced. The shorter bills are auctioned every week. The 1-year bill is auctioned monthly.
The Treasury also sells coupon-bearing issues. The common terms currently in use are 2, 3, 5, 7, 10 and 30-year maturities. The Treasury used to sell 4 and 20-year maturities but these are not currently on the menu. The Treasury has these various maturities on a monthly auction cycle.
As an example of this process, consider the 5-year Treasury note auction that took place on January 25, 2012. The terms for this sale were announced on January 19, 2012. The Treasury announced that the amount of the sale would be $35 billion, the date of the sale would be January 25, 2012, that the bonds would settle on January 31, 2012 and the maturity of the note would be January 31 2017.
“When Issued” trading
As soon as the basic terms are announced, the Treasury allows market participants to trade the note on what’s called a “when issued” or “w.i” basis. This means notes can be bought or sold on a yield basis. The ultimate coupon is not set until the actual auction. Once the coupon is decided, all transactions in the note are priced according to the effective coupon. The Treasury convention is to set coupons only in 1/8 point increments. If an awarded auction yield is 0.89%, the actual coupon on the note will be rounded to 0.875%. If the award should be 0.86%, the actual coupon will be rounded down to 0.75%. In our example, the 5-year auction takes place on January 25, with the bids typically due by 1:00 pm Eastern (although this may vary, based on holiday scheduling).
Bids are submitted
The various bidding parties submit their bids to the Treasury on a yield basis with the amount of the bid attached. This is done electronically. The “w.i.” process helps the dealers determine at what level to submit their bids. The actual auction is called a “Dutch Auction” process. This means that whatever bid level is submitted the entire auction is awarded at a single yield. In our example the “w.i.” trade on the January 5-year auction suggested a yield of 0.899% was going to be the award yield. Bidders for the note submit bids based on the extent to which they really want to buy securities. If a bidder submitted a bid of 0.88% for 10 million bonds, they would be awarded a yield of 0.899% on the 10 million. If the bid was 0.91%, the bidder would not be awarded any bonds as the yield bid was too high. It is this bidding process that determines the level of the yield award.
Reading the results
A successful auction is determined by the awarded yield, the par amount of bids submitted relative to the amount being auctioned, and the extent to which there is substantial investor participation. The awarded yield is measured against the “w.i.” trading level at the time of auction. As an example, if the “w.i.” yield was trading at 0.89% and the auction award is 0.87% that would be considered a successful sale, as it beat expectations. The second measure of success is the amount of bids received relative to the bonds sold in the auction. If the Treasury is selling 35 billion in bonds and the amount of total bids submitted was 122 billion par, the coverage ratio would be announced at 3.5 times. The larger that number, the more successful the auction is deemed to be. The last factor used to determine the success of the auction is the percentage of bonds allocated to each category of bidder.
The three categories are the primary dealers, direct bidders and indirect bidders. There are some 21 designated primary government bond dealers. These dealers include firms such as Goldman Sachs and Citibank. They are required to have a bid to help the Treasury underwrite the debt. That bid doesn’t have to be aggressive, but they have to submit one. Direct bidders are large domestic investors such as state funds and pension funds that are able to submit their bids directly to the Treasury. This is not the dominant bidding force but their varying size can influence the auction results. Indirect bidders are usually considered foreign entities, mostly central banks around the world. The fewer bonds that the primary dealers have to underwrite, the more successful the auction is deemed to be as more of the bonds go to ultimate investors right away. The dealers have less excess inventory to distribute.
A successful auction can provide a big boost to the level of bond prices, at least temporarily.
The impact of bond auctions on interest rates in 2012
It is important to recognize that a $1.3 trillion deficit is all new borrowing. That is only part of the task. The Treasury also has maturities happening throughout the year. Since we are on a deficit-ballooning binge, the Treasury will be busy raising not only new money but sufficient funds to roll over existing debt. This has been true for the last several years but interest rates have been able to sink to historic lows anyway.
Factors that influence interest rates
Supply is certainly a factor in setting the level of interest rates, but it is not the only factor. Inflation, the flight to quality, the desire for duration, and not the least, Federal Reserve policy all influence the level of interest rates. The last few years have seen extraordinary developments on these various interest rate drivers:
- Inflation: Despite a huge expansion in the FOMC balance sheet and the huge growth in fiscal deficits, the level of U.S. inflation has been tame.
- Flight to quality: The European debt crisis and the incipient recession over there continue to drive investors into the relative safety of U.S. Treasury debt.
- Need for duration: The low rate environment of the last four years has been devastating to callable portfolios and duration is a scarce commodity. Treasuries are non-callable and have the best duration available.
- FOMC policy: The FOMC has just told us that they foresee the fed funds rate remain at extraordinarily low rates until late 2014.
In short, the forces that have kept interest rates low of late should remain in place in 2012. The supply of Treasuries will be big in 2012. The budget deficit makes this a certainty. How the markets absorb the debt will be determined by the demand based on the factors mentioned above.
Director of Investment Sales