Explaining the On-the-Run Puzzle
43 Pages Posted: 5 Feb 2014
Date Written: January 14, 2014
The on-the-run phenomenon is regularly found in the bond markets. The on-the-run phenomenon is the yield difference observed when a new bond issue comes to market from the same issuer and gets a better price (lower yield given equivalent duration) from the market than the older issue. This paper proposes and tests a liquidity model to explain phenomenon using entropy as our liquidity measure. The yield differential results from the illiquidity cost of the older issue that has increased as a result of progressing through stages, which typically occur in an entropy process. We find that a model employing an entropy measure largely explains the on-the-run phenomenon, by accounting for over two-thirds of the liquidity differential for on-the-run corporate bonds.
Keywords: Bonds, liquity, valuation
JEL Classification: G19
Suggested Citation: Suggested Citation