What Is an Auction Market?

In an auction market, buyers enter competitive bids and sellers submit competitive offers at the same time. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. Matching bids and offers are then paired together, and the orders are executed. The New York Stock Exchange (NYSE) is an example of an auction market.

Auction Market Process

The process involved in an auction market differs from the process in an over-the-counter (OTC) market. On the NYSE, for example, there are no direct negotiations between individual buyers and sellers, while negotiations occur in OTC trades. Most traditional auctions involve multiple potential buyers or bidders, but only a single seller, whereas auction markets for securities have multiple buyers and multiple sellers, all looking to make deals simultaneously.

Double Auction Markets

An auction market also known as a double auction market, allows buyers and sellers to submit prices they deem acceptable to a list. When a match between a buyer’s price and a seller’s asking price is found, the trade proceeds at that price. Trades without matches will not be executed.

Examples of the Auction Market Process

Imagine that four buyers want to buy a share of company XYZ and make the following bids: $10.00, $10.02, $10.03 and $10.06, respectively. Conversely, four sellers wish to sell shares of company XYZ, and these sellers submitted offers to sell their shares at the following prices: $10.06, $10.09, $10.12 and $10.13, respectively.

In this scenario, the individuals that made bids/offers for company XYZ at $10.06 will have their orders executed. All remaining orders will not immediately be executed, and the current price of company XYZ will be $10.06.

Treasury Auctions

The U.S. Treasury holds auctions to finance certain government financial activities. The Treasury auction is open to the public and various larger investment entities. These bids are submitted electronically and are divided into competing and noncompeting bids depending on the person or entity who places the recorded bid.

Noncompeting bids are addressed first because noncompetitive bidders are guaranteed to receive a predetermined amount of securities as a minimum and up to a maximum of $5 million. These are most commonly entered by individual investors or those representing small entities.

In competitive bidding, once the auction period closes, all of the incoming bids are reviewed to determine the winning price. Securities are sold to the competing bidders based on the amount listed within the bid. Once all of the securities have been sold, the remaining competing bidders will not receive any securities.

What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.

Understanding Average Life

Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond’s principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.

What Is the 30-Year Treasury?

The 30-Year Treasury is a U.S. Treasury debt obligation that has a maturity of 30 years. The 30-year Treasury used to be the bellwether U.S. bond but now most consider the 10-year Treasury to be the benchmark.

Understanding the 30-Year Treasury

The U.S. government borrows money from investors by issuing debt securities through its Treasury department. Debt instruments that can be purchased from the government include Treasury bills (T-bills), notes, and Treasury Inflation-Protected Securities (TIPS). T-bills are marketable securities issued for terms of less than a year, and Treasury notes are issued with maturities from two to 10 years.

TIPS are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). When there is inflation, the principal increases. When deflation sets in, the principal decreases. U.S. Treasury securities with longer-term maturities can be purchased as U.S. Savings bonds or Treasury bonds.

Special Considerations

Treasury bonds are long-term debt securities issued with a maturity of 20 years or 30 years from the issue date. These marketable securities pay interest semi-annually, or every six months until they mature. At maturity, the investor is paid the face value of the bond. The 30-year Treasury will generally pay a higher interest rate than shorter Treasuries to compensate for the additional risks inherent in the longer maturity. However, when compared to other bonds, Treasuries are relatively safe because they are backed by the U.S. government.

The price and interest rate of the 30-year Treasury bond is determined at an auction where it is set at either par, premium, or discount to par. If the yield to maturity (YTM) is greater than the interest rate, the price of the bond will be issued at a discount. If the YTM is equal to the interest rate, the price will be equal to par. Finally, if the YTM is less than the interest rate, the Treasury bond price will be sold at a premium to par. In a single auction, a bidder can buy up to $5 million in bonds by non-competitive bidding or up to 35% of the initial offering amount by competitive bidding. In addition, the bonds are sold in increments of $100 and the minimum purchase is $100.

30-Year Treasury vs. Savings Bonds

U.S. Savings bonds, specifically, Series EE Savings bonds, are non-marketable securities that earn interest for 30 years. Interest isn’t paid out periodically. Instead, interest accumulates, and the investor receives everything when they redeem the savings bond. The bond can be redeemed after one year, but if they are sold before five years from the purchase date, the investor will lose the last three months’ interest. For example, an investor who sells the Savings bond after 24 months will only receive interest for 21 months.

Because the U.S. is seen as a very low-risk borrower, many investors see 30-year Treasury interest rates as indicative of the state of the wider bond market. Normally, the interest rate decreases with greater demand for 30-year Treasury securities and rises with lower demand. The S&P U.S. Treasury Bond Current 30-Year Index is a one-security index comprising the most recently issued 30-year U.S. Treasury bond. It is a market value-weighted index that seeks to measure the performance of the Treasury bond market.

What Is a 10-Year Treasury Note?

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity. The U.S. government partially funds itself by issuing 10-year Treasury notes.

Understanding 10-Year Treasury Notes

The U.S. government issues three different types of debt securities to fund its obligations: Treasury bills, Treasury notes, and Treasury bonds. Bills, bonds, and notes are distinguished by their length of maturity.

Treasury bills (T-bills) have the shortest maturities, with durations only up to a year. The Treasury offers T-bills with maturities of four, eight, 13, 26, and 52 weeks. Treasury notes have maturities ranging from a year to 10 years, while bonds are Treasury securities with maturities longer than 10 years.

Treasury notes and bonds pay interest at a fixed rate every six months to maturity, and are then redeemed at par value, meaning the Treasury repays the principal it borrowed.

In contrast, T-bills are issued at discounts to par and pay no coupon payments. The interest earned on T-bills is the difference between the face value repaid at maturity and the purchase price paid.

The 10-Year Note Yield as a Benchmark

The 10-year T-note is the most widely tracked government debt instrument in finance. Its yield is often used as a benchmark for other interest rates, like those on mortgages and corporate debt, though commercial interest rates do not track the 10-year yield exactly.

Below is a chart of the 10-year Treasury yield from March 2019 to March 2020. Over that span, the yield steadily declined with expectations that the Federal Reserve would maintain low interest rates or cut them further. In late February 2020, the decline in yield accelerated amid growing concerns about the economic effects of the COVID-19 pandemic. As the Fed ordered an emergency rate cut of 50 basis points in early March, the decline of the 10-year yield accelerated even further, with the yield dropping to 0.32%, a record low, before rebounding.

The Advantages of Investing in Treasury Notes

Fixed-income securities offer important portfolio diversification benefits, because their returns are not correlated with the performance of stocks.

Government debt and the 10-year Treasury note in particular is considered a relatively safe investment, so its price often (but not always) moves inversely to the trend of the major stock-market indices. In a recession, central banks tend to lower interest rates, which lowers the coupon rate on new Treasuries and, subsequently, makes older Treasury securities with higher coupon rates more desirable.

Another advantage of investing in 10-year Treasury notes and other federal government securities is that the coupon payments are exempt from state and local income taxes. However, they are still taxable at the federal level. The U.S. Treasury sells 10-year notes and those with shorter maturities, as well as T-bills and bonds, directly through the TreasuryDirect website via competitive or noncompetitive bidding, with a minimum purchase of $100 and in $100 increments. Treasury securities can also be purchased through a bank or broker.

Investors can choose to hold Treasury notes until maturity or sell them early in the secondary market. There is no minimum holding term. Although the Treasury issues new T-notes of shorter maturities every month, new 10-year notes are issued only in February, May, August, and November. In other months, the Treasury sells additional 10-year notes from the most recent issue in what is known as a re-opening. Re-opened notes have the same maturity date and coupon interest rate as the original issue, but a different issue date and a purchase price reflecting subsequent change in market interest rates.

All T-notes are issued electronically, meaning investors cannot obtain paper certificates. Series I Savings Bonds are the only Treasury securities currently issued in paper form, and they can only be bought in paper form with the proceeds of a tax refund.