This Is What's Actually Happening When The Government Auctions Bonds

Joe Weisenthal (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast.

Tracy Alloway (0:16)

And I'm Tracy Alloway.

Joe Weisenthal (0:17)

Tracy, there's a lot of talk about the deficit and the debt these days. For a long time, maybe that sort of story went away, but with the tax cuts and people wondering when the next downturn comes back, it really feels like government debt is a big story again.

Tracy Alloway (0:37)

Yeah, absolutely. We've seen lots of talk about bond vigilantes staging a comeback. We've seen lots of forecasts from various analysts about just how big the US deficit is going to get given Trump's propensity to borrow and also enact fiscal stimulus.

There is a lot to discuss when it comes to the world of US government debt nowadays.

Joe Weisenthal (1:00)

There absolutely is. And I think one of the things that's always driven me crazy, I think both of us crazy, is the sort of naive view about how people talk about government debt, particularly US government debt.

There's this view often that sort of sees the government as just sort of a typical borrower, like a household or a person trying to borrow money to buy a car. And as we know, it doesn't really work that way. And that can really lead people to a lot of assumptions, like about what interest rates are gonna do and what the market is gonna do.

Tracy Alloway (1:36)

So I know you say it's a naive viewpoint, but I'm gonna make a confession here and say that in my head, I understand the point that the US government is not the same as the head of a household who's totting up their income versus their expenditure every month. But deep down in my gut, I have always been uncomfortable with the notion that the US can borrow extraordinary amounts of money and not have major, major impacts. So I'm actually really excited to dig into this subject because hopefully it'll make me feel better.

Joe Weisenthal (2:13)

Yeah, I agree. There's a non-intuitiveness about it. And even if you say like, oh, you know, the US creates its own money and borrowing for the government is not the same as it is with the household.

I know what you're saying about, you're like, well, yeah, surely we must be still getting close to some risk. So hopefully we can maybe use this episode to get a little more comfortable with thinking about what government debt means in a slightly different manner.

Tracy Alloway (2:41)

Yeah, that sounds great.

Joe Weisenthal (2:43)

Great. So today I'm very excited to welcome to the podcast Brian Romanchuk.

He is the author of the Bond Economics blog. He's a financial consultant. He's written about the bond market and what really happens. He's a veteran of the financial industry. And he is going to help us understand what's really happening when the government issues all this debt, which of course is a major theme of the news these days.

Brian Romanchuk, thank you for joining us on Odd Lots. Let's start with the big question. When someone or a bank or an investor is buying a government bond, what does actually happen?

Brian Romanchuk (3:32)

On paper, it does look similar to buying another bond.

You transfer money to someone in exchange for a security, which has a QCIP. So there is some similarity. You're going through the same settlement process, and you end up with rights. If you buy it 10 million, once you have control of it, then you get certain contractual payments up until the bond maturity. And any bond, well, standard bonds all have the same sort of structure, will give you a certain coupon, and then there's a final principal payment. So the cash flow perspective, all bonds are similar in that sense.

Tracy Alloway (4:11)

So at the risk of using a terrible cliche, you're getting this IOU from the government, essentially. It comes with a coupon, which kind of informs the yields that you're gonna get.

Most people, when they think of US government debt, they're gonna think of treasuries, obviously, and they're gonna think of the US Treasury. Is it the US Treasury who is actually selling these things, or are there other entities involved?

Brian Romanchuk (4:37)

The US Treasury, the auctioneer, as a Canadian, I forgot the exact details, but it's done, there's an auction.

And the auction is, they say there's gonna be a certain number of bonds, and then at a certain maturity, and then they line up bidders, and most of the bidding comes from, they're called the primary dealers. It's mainly banks, but they're security dealers that deal with the Fed, and they're obligated to bid, and they do most of the bidding. Other entities, you can do a non-competitive bid, but that's usually a small part of the market. And once all the bids come in, you don't give a price, you just say, I want to buy it at this yield, and then once all the bids come in, you say the lower yield is essentially a higher price. The lowest yields to buy all the bonds win the auction, and they get the bonds delivered to them. And then usually the primary dealers sell them on to other investors, like pension funds, people like us in the secondary market.