Why There are On-the-Run/Off-the-Run Phenomena

Abstract

This paper offers an alternative explanation for the on-the-run/off-the-run phenomena in T-securities, namely, the concentration of trade in recent issues, cost-of-trading differential and price differential between recent issue and earlier – issued bonds. We claim that optimizing the cost-of-trading and economizing on the trading cost are at the heart of the phenomena. Two distinct groups of market participants trade in T-securities: long-term buy-and-hold investors and market-makers/hedgers; the bulk of trades are initiated by hedgers, who trade in T-notes for reasons exogenous to the T-securities market and who hold positions for short period of time. To minimize their trading costs, hedgers concentrate all their trades in one security out of many available; that security can be selected by fiat ( as in Japan in 1980s’), or by overt convention or by tacit understanding. Concentration of trades drives the cost of trading in that security down, and (via equilibrium considerations) causes valuation differences between new and old issues. The valuation difference brings in arbitrage opportunities and ultimately causes the emergence of specialness. Our insight allows a parsimonious explanation of on-the-run/off-the-run yield premium, the concentration of trades in few securities and emerges of “specialness” among the on-the-run securities mainly. We also show that the OTR arrangement is societaly – optimal by minimizing the trading costs in the economy.