Notes on Bonds: Illiquidity Feedback During the Financial Crisis

52 Pages Posted: 1 Jul 2015 Last revised: 30 Dec 2017

See all articles by David K. Musto

David K. Musto

University of Pennsylvania - Finance Department

Greg Nini

Drexel University - Department of Finance

Krista Schwarz

University of Pennsylvania - Finance Department

Date Written: December 29, 2017

Abstract

We trace the evolution of extreme illiquidity discounts among Treasury securities during the financial crisis, when bond prices fell more than six percent below more-liquid but otherwise identical notes. Using high-resolution data on market quality and trader identities and characteristics, we find that the discounts amplify through feedback loops, where cheaper, less-liquid securities flow to investors with longer horizons, thereby increasing their illiquidity and thus their appeal to these investors. The effect of the widened liquidity gap on transactions costs is further amplified by a surge in the price liquidity providers charge for access to their balance sheets in the crisis.

Keywords: liquidity, feedback, Treasury market, financial crisis, limits to arbitrage, repo

JEL Classification: E43, G12, G14, G22

Suggested Citation

Musto, David K. and Nini, Gregory and Schwarz, Krista, Notes on Bonds: Illiquidity Feedback During the Financial Crisis (December 29, 2017). Available at SSRN: https://ssrn.com/abstract=2625107 or http://dx.doi.org/10.2139/ssrn.2625107

David K. Musto

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Gregory Nini

Drexel University - Department of Finance ( email )

LeBow College of Business
Philadelphia, PA 19104
United States

Krista Schwarz (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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