What it means
The US Treasury sells new securities at regular auctions, and each new issue of a given maturity becomes the on-the-run security until the next one is sold. When a newer issue arrives, the previous one becomes off the run.
The label therefore changes hands every time a fresh auction takes place. Traders concentrate on the newest issue because it is easiest to find a buyer or seller.
Large trades can be made with very small gaps between the buying and selling price. This liquidity is valuable, and investors are willing to accept a slightly lower yield in exchange for it.
The difference in yield between on-the-run and off-the-run securities of similar maturity is called the liquidity premium. In calm markets it may be a few hundredths of a percentage point, and in stressed markets it can widen sharply as investors rush towards the securities that are easiest to sell.
Some traders try to profit from the gap, and the strategy can lose heavily if the gap widens instead of narrowing. On-the-run yields are used as benchmarks across the economy.
Corporate bonds, mortgages and many loans are priced as a spread over the matching on-the-run Treasury, so a change in this yield feeds directly into borrowing costs. Businesses with floating rate debt or planned bond issues therefore track these yields closely.
A small nuance is that the on-the-run status is temporary, so a position that looks liquid today may become less liquid after the next auction. Treasury teams that hold such bonds as a reserve should consider how easily they could sell older issues in a hurry.
For practical cash management, the liquidity gap is usually small but should not be assumed to be zero.
In practice
Real-world examples.
Example
A company treasurer invests $25 million of surplus cash in the newest 2-year note because she may need to sell part of it at short notice. She accepts a slightly lower yield than older notes offer. The extra liquidity is worth more to her than the extra return.
Example
A hedge fund notices that the 10-year on-the-run note is trading with a yield 5 basis points below the previous issue. It buys the older note and sells the newer one, expecting the gap to close as the new note ages. The trade works only if market conditions stay calm.
Example
A lender quotes a loan to a retailer at the on-the-run 5-year Treasury yield plus 2.5%. The retailer's finance director asks what happens to the rate when the next auction changes the benchmark. The lender confirms that the loan will use whichever note is current on the day the rate is fixed.
Formula
Calculation
Liquidity premium = off-the-run yield - on-the-run yield
Price effect = liquidity premium x modified duration x position size
Suppose the on-the-run 10-year note yields 4.20% and a similar off-the-run note yields 4.26%. The liquidity premium = 4.26% - 4.20% = 0.06%, or 6 basis points.
If the notes have a modified duration of 8 (meaning the price moves about 8% for each 1% change in yield), the price effect on a $10,000,000 position is 0.06% x 8 = 0.48%, and 0.48% x 10,000,000 = $48,000.
So buying the older note at a yield 6 basis points higher would give a price about $48,000 cheaper for the same cash flows, as compensation for lower liquidity.Case study
Seen in the real world.
Northgate Capital is an illustrative, fictional fund that held $40 million of older Treasuries to pick up a small extra yield. During a sudden market scare, investors moved heavily into the newest issues, and the older bonds became harder to sell without a price cut.
The fund needed $8 million of cash to meet redemptions and had to sell its older bonds at a discount of 0.40% to the prices it had expected, a cost of $32,000. A competitor that had held on-the-run bonds sold at near-quoted prices.
The fund's board revised its policy so that a minimum share of the cash reserve would sit in the most recent issues. The illustrative lesson is that the small yield advantage of older bonds is payment for accepting liquidity risk, and that risk shows up when cash is needed most.
Watch out
Common mistakes.
- Assuming all Treasuries are equally liquid, when the newest issue is much easier to trade than older ones.
- Treating the yield gap as a free return, when it is compensation for lower liquidity.
- Forgetting that the on-the-run bond changes after each auction, which alters the benchmark that other prices reference.
Questions
People also ask.
What makes a Treasury on the run?
It is the most recently auctioned security for its maturity, and it stays on the run until the next auction of that maturity.
Why do on-the-run bonds have lower yields?
Their price is higher because investors pay a premium for the ability to trade quickly and cheaply.
Are on-the-run Treasuries safer?
They carry the same government credit risk as older issues, so the difference lies in liquidity and trading cost and not in the chance of being repaid.
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