How Soaring Yields Are About To Make A 5 Year Bond Auction Into A 7 Year Reopening

As part of today's 2,5, 7-year Treasury refunding notice, the US Treasury issued a curious special announcement. To wit:

THE RESULTS OF THE 5-YEAR NOTE AUCTION COULD RESULT IN THE UNSCHEDULED REOPENING OF THE 7-YEAR NOTES OF SERIES P-2018 (CUSIP NO. 912828RE2)

If the auction of the 5-year Treasury notes to be held Wednesday, August 28, 2013, results in a high yield in a range of 1.500% through and including 1.624%, the 5-year notes will be considered an additional issue of the outstanding 1-1/2% 7-year notes of Series P-2018 (CUSIP No. 912828RE2) originally issued August 31, 2011. The additional issue of notes would have the same CUSIP number as the outstanding notes, which are currently outstanding in the amount of $29,886 million. If the auction results in the issuance of an additional amount of the outstanding 7-year notes rather than a new 5-year note, it will be indicated in the Treasury's auction results press release and by a special announcement. Any net long position reporting in this auction should be in regard to the 5-year notes.

What this means in plain English is that due to spiking yields on the left end of the belly, the 5 Year which will be issued next week on August 28, may have identical characteristics as the 7 Year bond issued on August 31 of 2011, (which means it is synthetically a 5 Year 2 years after its issuance). And if the yield prices in a range of 1.5%-1.625%, and thus has a cash coupon of 1.5%, the two issues will be fused into one. Of course, if the ongoing blow out in yields continues, the 5Y which is currently yielding 1.673% may not be in danger of overlapping the 7Y and becoming an unexpected "reopening." However, there is some hope for PIMCO who was heavily pitching the 5Y just a month ago, that the drubbing on this point of the curve will end soon, and the yield will indeed drop making the auction a 7 Year 1.5% cash coupon reopening.

There are other nuances too. For the full breakdown we go to Morgan Stanley's Guneet Dhingra who more fully explains this paradoxical outcome.

From Morgan Stanley:

Action At The Auctions

The coupons on the 5- and 7-year auctions next week will be closely watched by the market. There is a possibility that the 5-year note is auctioned with a coupon of 1.500%, thereby making it an unintentional re-opening of the 1.500% Aug18s (old 7s). The new bond would 1) get the same CUSIP as the old 7s, 2) qualify for FV deliverable basket, and 3) could have a slightly lower financing premium than the recent on-the-run 5s. If the coupon on the 7-year note is 2.50% or higher, it could become the new cheapest to deliver (CTD) bond for the TY December contract. We evaluate these implications in more details and also suggest the best trades around the 2-, 5- and 7-year auctions.

5-Year Auction: A New Auction of Older Bonds?

If the 5-year note auction on August 28 stops out at any level from 1.500% to 1.624%, the resulting note would have a coupon of 1.500% and mature on 8/31/2018, same as the rolled down old 7-year note.

Based on the Treasury’s stated policy in the past, we believe the newly auctioned notes would be deemed a re-opening of the old 7-year notes. This would be an unintentional re-opening, making it the first such instance in at least twenty years of Treasury coupon issuance. In 2004, such a possibility arose around the 3-year auction such that the newly auctioned security could have been exactly the same as an older 5-year original maturity security. The Treasury issued a press release1 stating that, under such an event, the newly issued 3-year notes would carry the same CUSIP number as the old 5s (see excerpt from the press release below).

If the auction of 3-year notes to be held Monday, November 8, 2004, results in a yield in a range of 3.000 percent through and including 3.124 percent, the 3-year notes will be considered an additional issue of the outstanding 3% 5-year notes of Series G-2007 (CUSIP No. 912828AN0) originally issued November 15, 2002. The additional issue of the notes would have the same CUSIP number as the outstanding notes, which are currently outstanding in the amount of $23,311 million. If the auction results in the issuance of an additional amount of the Series G-2007 notes rather than a new 3-year note, it will be indicated in the Treasury auction results press release.

Implications for the FV Futures Contract Basket

According to the CME’s guidelines for the FV contract, the eligible bonds for delivery in the FV contract should not have an original maturity of more than 5-years and 3-months. This raises the question: if the newly auctioned notes qualify as a re-opening of original maturity 7s, will they be deemed eligible for delivery into the FV basket?

The CME’s rules account for such a possibility, and would allow the addition of the old 7s to the FV basket along with the newly auctioned re-opened amount (see excerpt below).

If the U.S. Treasury Department auctions and issues a Treasury security that meets these standards, such that said security is a re-opening of an extant Treasury issue that had not previously met these standards, then the extant Treasury issue shall be deemed to be a Treasury note meeting these standards and shall be added to the contract grade as of the issue date of said newly auctioned Treasury security.

The new issue will be a part of the FV deliverable bucket for the September 2013 contract until the June 2014 contract. If yields do not rise substantially such that the lowest maturity bonds in the FV basket are the cheapest to deliver, then this new issue could be the CTD for the June 2014 contract.

Implications for Financing Premium

If the new 5s are auctioned as re-opened 7s, there could be a slightly lower liquidity premium associated with the new 5-year note insofar as their availability as collateral in the repo market is concerned. This is because the Fed currently owns approximately $14bn of the old 7s which is available to the market through the Fed’s securities lending program. This would add a cushion of $14bn to the newly issued $35bn issuance (we expect an unchanged auction amount), lowering the typical specialness of the new on-the-run in the repo market.

Implications for Fed Purchases

If the new 5s are auctioned as re-opened 7s, the Fed could purchase the old 7s at a faster clip than it does currently. Exhibit 1 shows the fraction held by the Fed would lower from ~47% to 22%. Under the current Fed rules for individual bond purchases (See Exhibit 1 –right), this would allow them to purchase at a much faster clip until they increase their ownership to higher percentages again.