The price differences between on- and off-the-run Treasuries
do not indicate a great disparity in liquidity conditions (Chart E), but due to data limitations we do not have as granular a view into off-the-run markets.
Off-the-run Treasuries are those that were auctioned one or more auctions earlier, and thus most of them are already settled in investors' portfolios and traded less frequently.
(20) Of course, off-the-run Treasuries will mature one or two auction cycles earlier than on-the-run Treasuries with the same maturity, but the yield spreads used here have already been adjusted for this slight difference in maturity.
Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries
, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives.
On-the-run nominal Treasury securities were viewed as the ultimate liquid instruments, but even off-the-run Treasuries
benefited, which contributed to the sharp decline in their yields.
Reflecting this divergence, market participants have experimented with using off-the-run Treasuries
as references for bringing new corporate issues to market.(34) Unfortunately, the same feature that may make off-the-run Treasuries
a better gauge of Treasury market performance, namely, their relative lack of liquidity, also makes them more susceptible to idiosyncratic price changes and thus a poor hedging vehicle.
Considerable differences exist between the market liquidity of on-the-run and off-the-run Treasuries. Typically, on-the-run Treasuries are traded the most and enjoy the most liquid market.
The top of Chart 5 shows the average yields of 10-year off-the-run Treasuries and of 10-year on-the-run Treasuries.
Unfortunately, accurate data are unavailable on the relative trading volumes of TIPS and off-the-run Treasuries. However, there are good reasons for believing that TIPS are considerably less liquid than off-the-run Treasuries, so that the liquidity premium on TIPS exceeds the lower bound of 0.23 percentage point by a substantial margin.
Unfortunately, the same feature that may make off-the-run Treasuries a better gauge of Treasury market performance--their relative lack of liquidity--also makes them poor vehicles for hedging purposes as well as more susceptible to idiosyncratic price changes.
(16.) Fannie Mae stated that "the liquidity of the benchmark notes combined with the outstanding credit quality should cause benchmark notes to be viewed by many investors as a higher yielding alternative to off-the-run Treasuries" (http://www.fanniemae.com/markets/debt/benchmark_prod.html).
First, even prior to the crisis, spreads between swaps and off-the-run Treasuries were wide.