Term Structures of Liquidity Premia in the U.S. Treasury Market

Abstract

The issuing policy of the U.S. Treasury allows us to unambiguously isolate maturity-dependent liquidity premia in the Treasury market. We determine and analyze three term structures of liquidity premia obtained from observed yields of coupon STRIPS, observed yields of principal STRIPS, and synthetic yields derived via the bootstrapping of Treasury notes and bonds. Considering liquidity premia between coupon STRIPS and Treasury notes, we surprisingly find that short-term coupon STRIPS are more liquid than Treasury notes whereas long-term coupon STRIPS are less liquid. This structure is highly persistent and can be explained by stripping activity and volume, business uncertainty, and the Fed's monetary policy. In contrast, principal STRIPS do not trade at a significant yield difference relative to Treasury notes. Finally, we provide a liquidity-based explanation for the empirical puzzle that coupon and principal STRIPS with exactly the same cash flows trade at different yields.

Keywords: Bond Liquidity, U.S. Treasury STRIPS, Coupon Stripping, Financial Crisis

JEL Classification: E43, G01, G12