The On-the-Run Liquidity Phenomenon

Abstract

We study the determinants of liquidity differentials between on-the-run and off-the-run U.S. Treasury bonds. To guide our analysis, we develop a parsimonious model of multi-asset speculative trading in which endowment shocks separate the on-the-run security from an otherwise identical off-the-run security. We then explore the equilibrium implications of these shocks on off/on-the-run liquidity differentials in the presence of two realistic market frictions - information heterogeneity and imperfect competition among informed traders - and a public signal. We test these implications by analyzing daily averages of intraday differences in bid-ask spreads for on-the-run and off-the-run three-month, six-month, and one-year U.S. Treasury bills and two-year, five-year, and ten-year U.S. Treasury notes. Our evidence suggests that i) off/on-the run liquidity differentials are economically and statistically significant, even after controlling for several of the bonds' intrinsic characteristics (such as duration, convexity, repo rates, or term premia), and ii) off/on-the-run liquidity differentials are smaller immediately following bond auction dates, and larger when the uncertainty surrounding the ensuing auction allocations is high, when the dispersion of beliefs across informed traders is high, and when macroeconomic announcements are noisy, consistent with our stylized model.