Coupon Spreads and Illiquidity in the Market for 10-Year Treasury Notes

Abstract

We find a strong systematic component in coupon spreads - the differences between notes' values and the values of replicating portfolios of fungible strips - that is strengthening over time. The first factor in coupon spreads is correlated with Hu, Pan, and Wang's (2011) measure of arbitrage capital. This correlation is also increasing over time. Notes become more valuable when their specialness is higher and predictably more sustained, so an increase in arbitrage capital may not reduce relative price deviations because of supply inelasticities resulting from short selling conventions. Indeed in the 1997 - 2003 period, the second factor in coupon spreads is negatively correlated with Hu, Pan, and Wang's measure.

Keywords: Coupon Spreads; Relative value trade; Frictions; STRIPS

JEL Classification: G320; L200; C110; C350