Government bond auctions and trading vs corporate bonds

How is a government bond auction run?

Governments sell debt by public auction, led by the treasury or finance ministry on standard procedures and a regular calendar. Corporate issuers instead use investment bank underwriters and time a deal when the market suits them.

An auction has four steps.

1. The debt office announces the amount and type of bonds, the auction and issue dates, the maturity and the bidding times.
2. Dealers, institutional investors and individuals bid. A competitive bid gives a price (or yield) and an amount; if the auction price ends up worse than the bid, it gets nothing. A non-competitive bid gives an amount only, accepts the auction price and is always filled.
3. All non-competitive bids are accepted first. Competitive bids are ranked from the lowest yield (highest price) upward until the offering is filled. The last yield needed is the cut-off yield , also called the stop yield. Bids above it receive nothing.
4. Securities are delivered and the proceeds paid.

Government auctionannounced, bid, allocated, settled

• Non-competitive bids Memorize amount only; always filled at the auction price; filled first
• Competitive bids Memorize yield and amount; ranked from the lowest yield up until the offering is filled
  • Single-price (uniform) Memorize every winner pays the cut-off price; broader distribution, steadier yields
  • Multiple-price (discriminatory) Memorize each winner pays its own bid; can concentrate large bids

$$C = \text{Offering} - \text{Non-competitive bids}$$

$$F = \frac{C - B}{A}$$

Here $C$ is the amount for competitive bids, $B$ the cumulative bids below the cut-off yield and $A$ the bids at the cut-off yield.

What changes between a single-price and a multiple-price auction?

Both rank bids the same way. They differ in what winners pay.

A single-price auction (uniform price) charges every winner the price at the cut-off yield, and the bonds carry one coupon. Bidders need not fear overpaying, so they bid more aggressively. The auction tends to lower the issuer’s cost, spread bonds more widely and reduce yield volatility. A government that suffers partly failed auctions may switch to it for that reason.

A multiple-price auction (discriminatory) charges each winner the price it bid. The same bond sells at different prices, and large bids can end up concentrated among a few bidders, because investors must accept their own price.

In the example, under single-price everyone, including the non-competitive bidders, pays the price at 4.00%. Under multiple-price, the 3.92% bidders pay the higher price that matches their lower yield. For a 10-year, 4% annual-pay bond, the price at 3.92% is 100.65, against 100.00 at 4.00%.

A primary dealer is a financial intermediary the government designates to take part in every auction with competitive bids. Primary dealers often act as the central bank’s counterparty when it trades securities for monetary policy, and pass on bids from foreign central banks and other indirect bidders. Investors may also bid directly through the debt office.

How do government bonds trade afterwards?

Once issued, government bonds trade much like private bonds: mostly over the counter through broker-dealers. A few markets use an exchange. The government is usually the largest borrower in its market and its bonds are the most liquid.

The most recently issued bond of each maturity belongs to the on-the-run securities . It is the most liquid and sets benchmark yields, and some of its trading is electronic. Older issues are off-the-run securities , which trade infrequently.

A difference that matters for the exam is who holds them. Many government bond investors have non-economic objectives.

Government bond holderstheir demand lowers sovereign borrowing costs

• Central bank Use it monetary policy operations
• Foreign central banks and governments Use it currency reserves
• Banks and insurers Use it required or encouraged to hold them by regulation
• State and local governments Use it restricted from holding other securities

These holders lower sovereign borrowing costs relative to private issuers. The effect is strongest for issuers of a reserve currency , one that central banks hold in large amounts and that is widely used in trade and finance. The US dollar, euro, Japanese yen, British pound, Swiss franc, Australian dollar and Chinese renminbi are reserve currencies. The dollar holds the largest share of reserves by far.

How do government and corporate bonds compare?

	Government	Corporate
Primary sale	public auction on a regular calendar	underwritten deal, timed opportunistically
Intermediaries	primary dealers	underwriting banks, syndicate
Pricing	set by bids (cut-off yield)	negotiated with underwriters, spread over benchmark
Secondary market	OTC, deepest liquidity, on-the-run benchmarks	OTC, liquidity varies widely
Holders	many with policy or regulatory motives	mainly return-seeking investors

Go deeper Why a single-price auction can lower the issuer's cost

In a multiple-price auction a bidder who bids too aggressively pays too much (the winner’s curse). Bidders protect themselves by bidding higher yields, which raises the issuer’s cost. In a single-price auction the price depends on the cut-off, not on the bidder’s own number, so bids can be more honest and the cut-off yield is often lower.

Go deeper When-issued trading before an auction

Between the announcement and the auction, dealers often trade the new bond on a when-issued basis, promising to deliver it after it is issued. The when-issued yield gives bidders a market-based guide to the likely cut-off yield.

Go deeper Reserve currency status and its funding advantage

A reserve currency creates steady foreign demand for the issuer’s debt, because other countries must hold it for trade and as a store of value. That demand lets the issuer borrow more cheaply than its own economy alone would justify. The link to capital flows and exchange rates is covered in the economics topic.

Go deeper Why on-the-run bonds usually yield a little less

Investors pay for liquidity. The newest bond is easy to buy and sell, so its price tends to be a touch higher, and its yield a touch lower, than an otherwise similar older bond. That gap is a liquidity effect and not a difference in credit quality.

Exam tip Rank by yield from the lowest up, subtract the non-competitive bids first, and the cut-off is where the cumulative total passes the amount needed.