Strategic Order Flow in the On-The-Run and Off-The-Run Bond Markets

We study the determinants of liquidity and price differentials between on-the-run and off-the-run U.S. Treasury bond markets. 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 both off/on-the-run price and 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 differences in market liquidity and yields 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 bid-ask spread differentials are economically and statistically significant, even after controlling for differences in several of the bonds' intrinsic characteristics (such as duration, convexity, or repo rates); ii) their corresponding yield differentials are neither, inconsistent with the illiquidity premium hypothesis; and iii) off/on-the-run liquidity differentials are larger for bonds of shorter maturity, immediately following bond auction dates, 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.