Auctions

• The U.S. Government currently auctions several Treasury securities to finance the public debt including bills, notes, bonds, Treasury Inflation Protected Securities (TIPS), and Floating Rate Notes (FRNs).

• The Treasury Department auctions securities on a regular and predictable basis. These securities are bought by primary government securities dealers, investment funds, foreign accounts, individual investors, and other investor classifications.

• Bids are submitted through Treasury Direct or through the Treasury Automated Auction Processing System (TAAPS). Investors without access to TAAPS can bid through broker-dealers or depository institutions with access to TAAPS.

The U.S. Treasury Department regularly borrows to finance the Federal Government's debt. The public debt of the United States doubled from $8.68 trillion in 2006 to $17.35 trillion in 2013. Approximately two-thirds of that debt is held in Treasury bills, notes, and bonds or "treasuries." The Treasury Department sells these securities at auctions via TAAPS (Treasury Automated Auction Processing System). The rest of the debt is held mostly in other nonmarketable debt securities, such as U.S. Savings Bonds, and is not sold through the auction process.

Primary dealers-banks and broker-dealers that trade in U.S. Treasuries with the New York Fed-are the largest group of buyers at auction. These financial institutions are active in buying and selling U.S. government securities. Other auction participants include investment funds, pensions and retirement funds, insurance companies, foreign accounts, non-profit organizations, and others. Only the designated primary dealers are required to bid a specified amount in every Treasury auction.

A much smaller volume of securities is purchased by individual investors who buy them directly from the Treasury Department through TreasuryDirect. Investors who purchase securities directly from the Treasury avoid the commission and brokerage fees that may be associated with purchases through an auction submitter or through the secondary market.

An Investment with Diverse Maturities

Treasury auctions began in 1929 with the sale of 3-Month Treasury bills, the shortest-term government security. At the time, longer-term securities-government notes and bonds-were sold only through underwriters, a practice that continued until the 1970s. Between 1973 and 1976, the auction process gradually replaced all other means of issuing notes and bonds.

Currently, the Treasury auctions a variety of securities including bills, notes, bonds, TIPS, and FRNs.

• Bills mature in one year or less and are currently offered in 4-, 13-, 26-, and 52-week maturities. Treasury bills (T-bills) do not pay interest prior to maturity and instead are sold at a discount to the par value.

• Cash management bills (CMBs) are occasionally offered in order to meet short-term financial needs. CMB maturities are set on an issue-by-issue basis and typically run from 1-day to approximately 1-year (most are issued with terms of less than three months). CMBs are awarded almost exclusively to primary dealers.

• Notes mature in two to ten years and are currently offered in 2-, 3-, 5-, 7-, and 10-year maturities. Treasury notes (T-notes) make a coupon payment every six months.

• Bonds have the longest maturity of more than ten years and are currently offered in only a 30-year maturity. Treasury bonds (T-bonds), like notes, make a coupon payment every six months.

• Treasury inflation-protected securities (TIPS) were introduced by the U.S. Treasury in 1997 and are currently offered in 5-, 10- and 30-year maturities. The principal amount of a TIPS security is adjusted to the Consumer Price Index (CPI), a commonly used measure for inflation. Therefore, the coupon payments of a TIPS security increases when inflation increases and decreases when inflation decreases. Treasury TIPS also make a coupon payment every six months.

• Floating rate notes (FRNs) were introduced in 2014 and are currently offered in only a 2-year maturity. The FRN pays a quarterly coupon that is indexed to the rate of the most recent 13-week bill offering. Therefore, the coupon payments of a FRN may increase when interest rates increase and decrease when interest rates decrease.

A Public Announcement

The modern auction process for treasury securities begins with a public announcement by the Treasury. The announcements are generally released several days before an auction; however Treasury can announce an auction on the same day and has done so in the past (typically only for CMB auctions). An auction announcement will contain the following information:

• Amount of the security Treasury is selling
• Auction date
• Issue date
• Original issuance date (in the case of a reopening)
• Maturity date
• Terms and conditions of the offering
• Customers eligible to participate
• Noncompetitive and competitive bidding close times
• Additional pertinent information

Once an auction is announced, bids for the security can be submitted through TreasuryDirect or through TAAPS. Recent announcements can be found on the TreasuryDirect.gov website.

The Bidding Begins

Bids are accepted immediately after the announcement of a security and are submitted electronically through the Treasury Automated Auction Processing System (TAAPS). All bids are confidential and can be submitted in two types: Non-competitive and competitive.

Non-competitive bids are generally submitted by small investors and individuals. All non-competitive bidders are guaranteed to receive securities. The amount of securities that may be sold to a single non-competitive bidder is limited to $5 million per auction. Foreign and International Monetary Authorities (FIMA) as well as the Federal Reserve's System Open Market Account (SOMA) can also participate noncompetitively, however, there are separate rules regarding their participation.

Non-competitive bidding typically closes at 11:00am for bills and FRNs and 12:00pm for notes, bonds, and TIPS on the day of the auction (Eastern Time).

Competitive bids are usually submitted by large financial institutions for their own accounts or on behalf of customers. Bids are submitted in terms of a discount rate for bills and a yield for coupon-bearing securities, stated in three decimal places. To ensure that the secondary market for Treasury securities remains competitive, bidders are restricted to receiving no more than 35 percent of the total amount of securities available to the public. Many of the securities bought by large dealers will later be sold and resold on the secondary market to companies, banks, other dealers, and individuals. Given their large bid sizes, primary dealers submit their competitive bids at the last possible moment, sometimes literally seconds before the auction closes.

Competitive bidding typically closes at 11:30am for bills and FRNs and 1:00pm for notes, bonds, and TIPS on the day of the auction (Eastern Time).

All submitted bids are consolidated in TAAPS where they are reviewed and processed to assure compliance under the Treasury's Uniform Offering Circular (UOC).

Determining the Winning Bids

Once the auction is completed, TAAPS will process all the bids received and determine the auctions' winning price. It does this first by subtracting the non-competitive bids from the public offering amount to determine the amount of securities available to the competitive bidders. For example, in an $11 billion auction, if $1 billion in non-competitive bids is received then $10 billion in securities will be awarded to competitive bidders.

In this example, six separate entities submitted competitive bids into the auction at the rates below.

Treasury auctions are designed in order to minimize the cost of financing the national debt. Therefore, TAAPS works its way down the list of competitive bids and accepts the total amount submitted at the lowest possible bid yields until the full offering amount has been awarded.

At this point there is $4 billion remaining for competitive bidding. However, there is a total of $6 billion in bids at the next lowest rate (3.000%). The highest accepted rate (3.000%) is known as the stop-out rate. When this occurs, each bidder at this rate is awarded a percentage of their total bid amount. The allocation percentage is calculated by dividing the remaining competitive offering by the total amount bid at the stop-out rate.

Remaining Competitive Offering $4,000,000,000
Total Bids at Stop-Out Rate (3.00%) = $6,000,000,000 = 66.7%

In the Treasury auction example above, securities would be awarded to the first four bidders only. Bidder 1 and Bidder 2 would each be awarded in full, whereas Bidder 3 and Bidder 4 would each receive a partial allocation of $2 billion (66.67% x $3.0 billion bid).

Treasury sells its securities to the public through single-price auctions, where both successful competitive bidders and noncompetitive bidders buy securities at a price that equals the highest accepted rate (3.000% in the example below) regardless of the rate or yield they submitted. The detailed list of accepted and rejected competitive bids is not released to the public, but the total amount of bids received and total amounts accepted are made available. In addition, the high, low, and median accepted rates as well as other details on the composition of auction bidders are released to the public usually within two minutes of the auction close. The awarded securities are then issued (at the predetermined date in the future) via the Federal Reserve's Fedwire Securities Service to those successful bidders.

Treasury Auction Calendar

Treasury auctions are held on a regular basis, generally as follows:

Certain securities (e.g. 10-year note, 30-year bond, TIPS, FRN) have reopenings. In a security reopening, the U.S. Treasury issues additional amounts of a previously issued security. The reissued security has the same maturity date and coupon interest rate as the original security, but with a different issue date and usually a different purchase price.

Treasury Buyback Program

In 2000, Treasury announced the introduction of debt buybacks. Debt buybacks were used as a tool by Treasury in order to manage the public debt. This program enhanced the liquidity of Treasury benchmark securities, which promoted overall market liquidity and helped reduce the government's interest cost over time. Buybacks also helped prevent a potentially costly and unjustified increase in the average maturity of American debt by paying off debt that had substantial remaining maturity.

The U.S. Treasury halted its buyback operation in April 2002, but recently tested the repurchase of a small amount of Treasury debt in October 2014. Treasury has stated that the transactions should not be viewed as a precursor of any policy change, but rather to ensure that the systems still function properly.

Problem Set

Please put your answers on a separate sheet(s) rather than this question sheet.

1. A T-bill that has 105 days until maturity is selling for $9,975. The T-bill has a par value of $10,000.

a. Calculate the T-bill's quote discount yield.
b. Calculate the T-bill's bond equivalent yield.
c. Calculate the T-bill's EAR.

2. Using the attached Treasury News, answer the following question.

a. What is the stop-out price for this auction?
b. What percentage of total tendered bids were noncompetitive bids?
c. What percentage of total accepted bids were noncompetitive bids?
d. Of total accepted bids, what percentage went to Primary Dealers?
e. Compute the bid-to-cover ratio for this auction.
f. Show how the investment rate is calculated.

3. Using a flow diagram illustrates the difference between a repurchase agreement and a reverse repurchase agreement.

4. Suppose you purchase 90-day commercial paper with a par value of $1,000,000 for a market price of $998,250. Calculate the discount yield, bond equivalent yield, and equivalent annual yield on this commercial paper.

5. Explain the column headings in the following Treasury bill auction results. Show how the price per $ 100 is calculated.

6. Suppose Big Bank enters a reverse repurchase agreement agreeing to buy T-bills from a dealer at a price of $ 34,950,000 with a promise to sell them back at a price of $35,000,000. Calculate the discount yield, bond equivalent yield, and equivalent annual yield for the following maturities.

a. 7-day maturity
b. 14-day maturity
c. 21-day maturity

7. What is the bid price of a $10,000 par value T-bill with a bid rate of 1.50 percent if there are 5, 10, 25, 50, 100, and 180 days to maturity. (Use your spreadsheet software to complete this question.

8. An investor purchased a three-month, $1,000,000 face value CD, which will pay a 5.0 percent annual interest rate.

a. If the market rate on the CD rises to 5.5 percent, what is its current secondary market value?
b. If the market rate on the CD falls to 4.5 percent, what is its current secondary market value?

9. You can purchase commercial paper of Citicorp for $ 495,000. The commercial paper has a face value of $ 500,000 and is 45 day from maturity. Calculate the discount yield and bond equivalent bond yield on Citicorp's commercial paper.

10. Draw a flow chart explaining the life-cycle of a bankers' acceptance; i.e., from creation to maturity.