Impact of Liquidity on Bond Spreads

The various bonds trading in the market can have different liquidity. A highly liquid bond will trade very frequently, in large volumes, and will have a very low bid-ask spread. On the other hand a less liquid bond will trade less frequently and will have higher bid-ask spread.

The liquid Treasury notes/securities are called "On-the-run" securities, while the illiquid securities are called "Off-the-run" securities.

The yield of "off-the-run" securities will be higher than the "on-the-run" securities even if they have the same characteristics such as maturity and credit rating. The additional yield is the risk premium attributed to the liquidity risk present in the "off-the-run" securities.

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