Explaining the On-The-Run Puzzle with Corporate Bonds
Abstract
The on-the-run phenomenon is regularly found in the bond markets. It refers to the phenomenon of 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 introducing 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 three-quarters of the liquidity differential for on-the-run corporate bonds.
