Notes on Bonds: Liquidity at all Costs in the Great Recession

We address the connection between market stress and asset pricing by analyzing a large and systematic discrepancy arising among off-the-run U.S. Treasury securities during the crisis. We begin by showing that bonds traded for much less than notes with identical maturity and coupon. The gap exceeded five percent in December 2008. We then ask how the small differences between these securities, in particular their liquidity, could project to such a large gap in prices. We gauge the potential for bond-note arbitrage in two ways. First, with data on repurchase rates and fails, we highlight the frictions arbitrageurs encountered in funding a short position in the notes. Second, with daily transactions data on trades by insurance companies, who are large buy-and-hold fixed income investors, we relate demand for the expensive but liquid note to the cross section of insurers’ characteristics. The Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia PA 19104. Department of Finance: David Musto, (215) 898-2323, [email protected]. Department of Risk & Insurance: Greg Nini, [email protected], (215) 898-0310. Department of Finance: Krista Schwarz, (215) 898-6087, [email protected]. We are grateful to the Dean’s Research Fund of the Wharton School for data funding. We are particularly grateful to Michael Bulboff, who provided outstanding research assistance. All remaining errors are our own.