Understanding On-the-Run U.S. Treasuries: Liquidity & Yield

On-the-run Treasuries are the most currently issued Treasury bonds or notes. The most commonly traded form of a Treasury note of a specific maturity, the on-the-run Treasury is significantly more liquid than other forms of securities. Therefore, they tend to trade at a premium.

In theory, it means they generally come with a lower yield than their “lower-rent” cousin: off-the-run treasuries. This may not be the case in practice since markets are generally very efficient, so any meaningful mispricings between on-the-run and off-the-run Treasuries would tend to be neutralized as market participants take advantage of them using arbitrage.

Trading using On-the-Run Treasuries

Traders often successfully use the price difference between on-the-run and off-the-run securities as a trading strategy. They do the following:

1. Sell on-the-run security short
2. Use the sale’s proceeds to purchase the first off-the-run issue
3. Hold the off-the-run security for several months (usually around three)
4. Liquidate the security
5. Repeat the process

Because Treasuries are debt obligations held by the US government, they are typically viewed as low risk, as compared to other investment options.

On-the-Run Treasuries vs. Off-the-Run Treasuries

Again, on-the-run treasuries are the first issue the government offers of a bond or note with a given maturity. After reaching the period of maturity, the concerned treasury changes to an off-the-run treasury.

Off-the-run treasuries decrease in value/tradability as they pass from one issue to the next. As each new batch of Treasury notes10-Year US Treasury NoteThe 10-year US Treasury Note is a debt obligation that is issued by the US Treasury Department and comes with a maturity of 10 years. is printed, each issue of the older treasuries moves down the line – first issue, second issue, and so on – until the issues are no longer in demand.

Traders who are concerned with liquidity focus on on-the-run treasuries because such securities are generally in higher demand and therefore, it’s easier to find a buyer. Traders who aren’t necessarily concerned with liquidity or fast sales lean towards the more cost-effective off-the-run treasuries with higher yields.

The Liquidity Premium

When traders sell on-the-run treasuries (usually with the idea of buying a first-issue off-the-run treasury), they are usually able to get a liquidity premiumLiquidity PremiumA liquidity premium compensates investors for investing in securities with low liquidity. Liquidity refers to how easily an investment can be sold for cash. T-bills and stocks are considered to be highly liquid since they can usually be sold at any time at the prevailing market price. On the other hand, investments such as real estate or debt instruments from the buyer. This is because, as mentioned before, on-the-run treasuries are considered supremely liquid.

The liquidity premium is a compensatory amount that the buyer pays for the added liquidity. It’s also a bonus for the seller, who is likely to later invest in less liquid treasuries. The treasuries typically come with a longer maturity; they must be held for a longer period of time. The holder is thereby more exposed to market fluctuations and changes in the treasuries’ values.

Off-the-Run Yield Curve

It’s important to understand the difference in yield between on-the-run and off-the-run Treasuries. To understand the difference, the off-the-run yield curveYield CurveThe Yield Curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the yield an investor is expecting to earn if he lends his money for a given period of time.  The graph displays a bond's yield on the vertical axis and the time to maturity across the horizontal axis. needs to be explained.

The off-the-run yield curve is built on the price, yield, and maturity dates of all treasuries that are not part of the on-the-run issue (the most recently issued treasury).

Let’s put it into perspective with an example:

In January, the U.S. Treasury issues 5-year bonds, which are on-the-run treasuries. In May, the Treasury then issues the next batch of 5-year bonds, and the batch released in January becomes off-the-run treasuries. The yield curve is then structured around the off-the-run treasuries.

The yield curve is the structuring of interest rates – plotting the yield of bonds of similar qualities against their dates of maturity. This, in turn, sets the mark for the prices of the bonds. An off-the-run yield curve accounts for the treasuries that are trading on the secondary market, with lower values and comparatively higher yields.

Off-the-run yield curves are typically more accurate than when on-the-run treasury yields are used. It is due to the fact that on-the-run treasuries – due to a fluctuation in demand – go through price distortions that make their yield curves less reliable and skew pricing.

Final Word

Traders looking for liquidity seek out on-the-run treasuries. Traders willing to play the long game can hedge their bet by short-selling on-the-run treasuries for off-the-run treasuries, holding them for a period of time, and then liquidating them in order to repeat the process again.

Related Readings

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