Hedge Fund Strategies (11) – Liquidity-Based Yield Spreads

Liquidity is the ability to sell a security without significantly affecting its price. This is a positive attribute, and all things being equal, traders will pay more for securities with higher liquidity. U.S. Treasury bills, notes and bonds are among the most liquid instruments in the world, but even they are subject to the effects of liquidity, due to the way they are sold.

Treasury debt is sold at periodic auctions. T-Bills are auctioned weekly (on Mondays), 2 and 5 year notes monthly, and 10 year notes in Feb, Mar, May, Jun, Aug, Sept, Nov, and Dec. “On-the-run” securities are ones being sold at the immediately next auction; “off-the-run” securities are to be sold at subsequent auctions. In the secondary markets, on-the-run securities are always considered the most liquid and thus the most desirable. This is an artifact of cyclical increased demand around the time of a Treasury auction. Since on-the-run securities are more desirable, they trade at higher prices and lower yields than off-the-run securities. The yield difference between the on- and off-the-run securities is known as a liquidity spread.

A liquidity spread trade is one in which the relatively expensive on-the-run securities are shorted and an equivalent face value of cheaper off-the-run securities are purchased. The spread is captured by the trader in exchange for the liquidity risk he/she takes on. This liquidity risk is due to the possibility that in a down market, the less liquid security will undergo a larger price decline than the on-the-run security. Historically, the liquidity spread has averaged 15 to 20 basis points.

Another reason for the relatively higher demand for on-the-run bonds is their use to hedge positions in the when-issued (i.e. a forward contract for an about-to-be-issued security) market. Speculators short the when-issued forward contract in hopes of buying it back at a lower price in the auction. Owners can then borrow cash at a low special repo rate using the on-the-run bonds as collateral. This special rate can be much lower than the corresponding general repo rate, providing an opportunity for riskless arbitrage – borrow at the special rate and lend at the general rate. This extra value of on-the-run bonds, termed a convenience yield, reinforces the yield difference between on- and off-the-run bonds and is thus an added inducement for liquidity spread trades.

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Copyright 2011 Eric Bank, Freelance Writer

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