Ebook The Flight-To-Liquidity Premium In U.S. Treasury Bond Prices
Historically, fixed income markets have often experienced what are termed flights to quality where some market participants abruptly want to decrease their portfolio exposure to securities bearing credit risk. Bank runs and panics, credit crunches, and sudden declines in the market values of corporate bonds are all examples of the effects of a flight to quality. From an asset pricing perspective, of course, the decrease in the value of risky debt resulting from a flight to quality can readily be explained in terms of changes in perceived default probabilities and in the equilibrium required premium for bearing credit risk.
In recent years, however, a related but distinct phenomenon has been observed in the world’s financial markets: flights to liquidity. In a flight to liquidity, some market participants suddenly prefer to hold highly-liquid securities such as U.S. Treasury bonds rather than less-liquid securities. This is consistent with recent papers by Woodford (1990), and Holmström and Tirole (1996, 1998) who examine the role of the public sector in providing liquidity to financial markets. A recent example of a flight to liquidity was in the wake of the 1998 Russian default where Treasury bonds suddenly increased in value relative to less-liquid debt instruments, causing credit spreads to widen and resulting in major losses at Long Term Capital Management and many other highly-leveraged hedge funds. Of course, there may have been elements of both a flight to quality and to liquidity during the 1998 hedge fund crisis.
Given that flights to liquidity may occur, however, it is important to consider what effects a pure flight to liquidity may have on security prices. Standard asset pricing theory implies that the value of a security should equal the present value of its cash flows, and should not depend on how popular the security is as a trading vehicle. More specifically, if two securities have identical cash flows in all states of the world, then the two securities should have the same value even if one suddenly becomes more popular among investors during a flight to liquidity. Finding evidence of a significant flight-to-liquidity premium in the price of the more popular security would pose a challenge to traditional asset pricing theory.
This paper examines whether there are flight-to-liquidity premia in U.S. Treasury bond prices. In doing this, we compare Treasury bond prices with the prices of bonds issued by the Resolution Funding Corporation (Refcorp), a government agency created by the Financial Institutions Reform, Recovery, and Enforcement act of 1989 (FIRREA). Refcorp bonds differ from most other agency bonds (which usually bear some small credit risk) in that their principal is fully collateralized by Treasury bonds, and that full payment of coupons is guaranteed by the Treasury under the provisions of FIRREA. Thus, Refcorp bonds literally have the same credit risk as Treasury bonds. Since Treasury bonds are more liquid and thus popular among investors (particularly during flights to liquidity), comparing their prices with those of Refcorp bonds provides an ideal way of testing whether there are flight-to-liquidity premia in Treasury bond prices.
The results are surprising. We find that during the past decade, there are often large liquidity premia in Treasury bond prices. In some cases, these premia can represent as much as 10 to 15 percent of the value of the Treasury bond. An exploratory analysis reveals that these flight-to-liquidity premia are related to a variety of market sentiment measures such as changes in consumer confidence and in the amount of funds flowing into equity and money market mutual funds. Furthermore, the flight to-liquidity premia are directly related to changes in the supply of Treasury securities available to investors resulting from the recent Treasury buyback program. We argue that these results are unlikely to be explained by differences in tax treatment, perceived credit risk, transaction costs, repo financing costs, or legal and regulatory restrictions on bondholders. These results have important implications for current asset pricing models.
The remainder of this paper is organized as follows. Section 2 describes the Refcorp bonds. Section 3 discusses the data used in the study. Section 4 conducts the empirical analysis. Section 5 evaluates alternative explanations for the results. Section 6 makes concluding remarks.
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