Treasury Auctions Explained For People With Short Attention Spans

Given that the market took a sharp turn lower on Thursday afternoon after the results of a dogsh*t (technical finance term #8203) 30 year treasury auction that posted a stunning 5.3 bps tail and a bid to cover that was the lowest since December 2021, I thought it would be a good idea to refresh myself and my readers on…well, exactly what the f*ck all that stuff means.

Tail? Bid-to-cover? Beavis and Butthead had better luck understand things in Spanish class back at Highland High:

In plain terms, yesterday’s bond auction means the government sale of debt that is necessary to continue running the economic Ponzi scheme we call fiscal and monetary policy didn’t go quite as well as old crow Janet Yellen’s medicine show would have liked.

Why is understanding the rest of the jargon and nonsense about auctions important? Take a look at the equity market’s reaction to the 30Y auction on Thursday, courtesy of Mr. Durden over at Zero Hedge:

Chart: Zero Hedge

And so when you’re having the perfunctory happy hour discussion about “the day in markets” in your Patagonia vest in some douchebag bar in Tribeca full of everyone I’ve tried to avoid my entire life, wouldn’t you like to make some sense? Or, at least, fake it well like I do?

Zero Hedge’s full coverage of the disaster auction Thursday can be found here, though it’s probably worth a read after James’ below “…for Dummies” series on how to understand auction terminology, contained below.

The below explanation of how treasury auctions work was written in 2022 by James Lavish, CFA, who you can follow on Twitter here or subscribe to his newsletter here. I highly recommend both.

Treasury auctions can give us clues to the health or problems of the entire US financial system. But what are those clues and how can you tell?

Auction Terminology & Basics

First, this thread is about auctions by the US Treasury, selling bonds to finance US public debt. They have various maturities and names:

T-Bills are shorter than 1 yr
Notes are shorter than 10 yrs
Treasury Bonds are longer than 10 yrs
and Treasury Inflation Protection Securities (TIPS) and Floating Rate Notes (FRNs) have various maturities

These can all be referred to as 'bonds', but traders never refer to anything above 10-years as a 'note'. Treasury auctions occur regularly, and ~300 public auctions are held each year.

The US Treasury has auctioned about $11.2T of bonds in 2022 [when James’ original thread was written], so far. Big business. One that needs a lot of demand to keep this whole debt charade going.

Let’s clarify some definitions and rules to better understand what happens during an auction. First, to participate directly, a bidder must have an established account.

Institutions use TAAPS (Treasury Automated Auction Processing System), individuals use a TreasuryDirect account. Individuals can only place *non-competitive* bids, where they agree to accept whatever discount rate (yield) is set by the auction. Institutions can place either non-competitive or *competitive* bids, where the bidder specifies an interest rate they are willing to accept.

Institutions can also trade in advance of an auction, and then settle with each other when the auction happens. This is called the *when-issued* market and is pretty important to our discussion, so we’ll talk more about that in a bit.

Back To The Auction Itself

Once an auction begins, the Treasury first accepts all non-competitive bids and then auctions off the remainder of what it's looking to raise. This is where competitive bidders are unsure whether they'll be filled at their price. The process is called a *Dutch auction*.

For example, say the Treasury wants to raise $100 million in 10-year Notes with a 4% coupon. And say it receives $10 million of non-competitive bids.

The Treasury first accepts all these non-competitive bids and reduces the amount left for the Dutch auction to $90 million. If it then receives the following competitive bids:

$25 million at 3.88%
$20 million at 3.90%
$30 million at 4.0%
$30 million at 4.05%
$25 million at 4.12%

The bids with the lowest yield will be accepted first and then ascend up until the auction is filled.

Here, the Treasury needs to raise $100 million.

It first accepts $10 million of non-competitive bids, then all competitive bids up to 4.0% ($75 million), then $15 million of the 4.05% bids for $90 million total. So, those who bid 4.05% would receive half of their orders filled.

At auction's end, all bidders receive the same yield at the highest accepted bid.

In this case, $100 million of Treasuries were auctioned off at 4.05%.

On the face of it, this looks pretty bad, as the Treasury had to offer a higher yield to raise its target amount.

But how bad? And how can we tell?

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Metrics Of An Auction: The Good, The Bad, and The Ugly

The answer—per usual with Wall Street—lies in the expectations of pricing. Let’s turn to the metrics of an auction next to find out how.

Bid to Cover Ratio

One of the first things traders look at is the Bid to Cover ratio (often referred to as BTC). A simple statistic, this is just the total amount of bids received divided by the amount of bonds sold at an auction.

In the case above, the total bids amounted to $140 million and the auction was for $100 million of Notes, so the BTC ratio would be 1.4x.

Like many stats, what we're often looking for is changes from prior periods. Is the BTC ratio rising or falling? And how rapidly?

If market liquidity is drying up, this would be a good first indicator. If it drops low enough, it’s a major red flag. More on that in a minute.

Looking at the release of stats from [one of last year’s] US 10-year Note auctions, we can see at the bottom, in the footnotes, that this auction had a 2.37 BTC ratio

And looking at recent 10-year Treasury Note auctions, we see this is largely in line with the BTC we have been seeing, so no red flags here.

The High Yield

Another, usually much more important, metric to keep an eye on is the *stop price*, aka the *high yield* (see in press release above)—the actual yield received by bidders in the auction.

Two things we're looking for here. Remember how we said these securities trade in a when-issued market before and leading up to an auction?

This creates what is called the *snap price*. It sets the price expectations for an auction and is a critical piece of information for investors.

First, was the auction overbid or underbid? In overbidding, the stop (high yield) is lower than the snap (when issued yield), and this is usually seen as a solid auction. With underbidding, the stop is higher than the snap, indicating a weak auction.

To put it simply, the snap (when-issued) tells us how the bond traded leading up the auction, and the stop (high yield) tells us how strong the auction was itself.

The Auction Tail

Another thing we’re looking for with the high yield, and a bond-fan favorite is called the *auction tail*. The tail is the high yield minus the bond’s when-issued yield.

[QTR: In simpler, slightly less accurate terms, you can think of it as the spread between expected yield, pre-auction, and the reality of the high yield actually determined by the auction. Even simpler, but less accurate, you can think of it as a spread between expectations and reality for the auction, of sorts, with a higher spread meaning a bigger gap].

If there is no measurable tail, we say that the auction finished *on the screws*.

A negative tail means that the auction went better than expected, with higher-than-expected demand. But a positive tail tells us the auction did not go well because the yield realized in the auction exceeded market expectations, meaning weaker-than-expected demand.

Bottom line, the tail measures unanticipated Treasury demand shifts before auction. The larger the tail, the worse the auction.

And if we ever see a tail in the 4, 5, or 6 bps range, this would be considered disastrous in the bond world and mean things are breaking in US Treasuries. [QTR: Thus the importance of yesterday’s 5.3 bps tail…]

OK, so now we know that a low bid-to-cover could be a red flag, an underbid auction can be cause for some concern, and a big tail is a big no-no. But what exactly does it mean when a Treasury auction fails?

Treasury Auction Total Failure

Going back to the BTC ratio, you may wonder what happens if the Treasury holds an auction and receives fewer bids than face value of the securities they're selling.

This would mean the BTC falls below 1, and the Treasury failed to raise as much money as they expected. In the bond world, this is a failed auction and nothing short of catastrophic for the US Treasury.

So you may ask, with dwindling demand for USTs and active selling from Japan and China, is there a possibility of a failed auction soon? Why yes. Yes there is.

But there are a couple of fixes to prevent this from happening, at least yet.

See, US commercial banks are still flush with capital, as the Fed is receiving over $2.3T of reverse repo purchases daily [QTR: This number is closer to $1T daily now, as of November 2023]. This is extra cash that banks sell to the Fed overnight to be paid interest.

James has also written an entire Substack post about the repo and reverse repo market that you can read here for free.

One fix is the Fed adjusting commercial bank SLR requirements to let them hold more bonds in lieu of cash or cash-like instruments. Or, the Treasury could issue more short term notes and fewer bonds, allowing all this reverse repo money to be used in the auctions instead. But once that $2.3T runs out [QTR: again, now $1T], all bets are off, and QE infinity is on.

With all of that being said, now lets look back on Thursday’s auction tail, courtesy of a chart from Zero Hedge:

Given your newfound knowledge, I recommend reading this wrap up of the auction. Then, you can join 18K+ of James Lavish’s readers here: jameslavish.com.

As for me? I’m going for a couple cold ones. And not in Tribeca. F*ck those guys.

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