What are On-the-Run Treasuries?
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:
- Sell on-the-run security short
- Use the sale’s proceeds to purchase the first off-the-run issue
- Hold the off-the-run security for several months (usually around three)
- Liquidate the security
- 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 notes 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 premium 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 curve 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.
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.
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