In page 42 of the Schweser Book 5. It states that there are 2 problems with the “On the run plus selected issues” framework. The true yield for the on-the-run issues may be distorted if any of these issues are “cheap” in the repo market. I don’t understand why the repo market will distort the on-the-run yield. Any ideas? Thanks.
Bond dealers short on-the-run bonds to hedge their interest rate risk in other bonds. They short the on-the-run bonds because they are by far the most liquid and they do not want to try to find markets to hedge their risk. That means they need a steady supply of these bonds to deliver to purchasers. Thus, the on-the-run bonds are always “specials” in the repo market which means that if you have one, you can get a lower interest rate on a repo loan. Since you can get a lower rate on a loan by having one (it’s even been negative before) you would rather have an on-the-run bond if you’re doing repo than an off-the-run bond. That means its price is higher. Which means its yield is lower. In general, its yield will be lower by the value of the difference between the special rate and the gc rate over the time remaining when the bond will be on special.
Joey, you’re the man! Great explanation.
Thanks!!!
But per your explanation shouldn’t the on the run issues trade at a premium? The Op’s statement says they should be cheap on the repo market
Resurrecting a nearly-7-year-old thread?
Wow!
OP said that the yield is cheap (low); thus, the price is high, and vice-versa.
>>>Resurrecting a nearly-7-year-old thread?
Lol! Didn’t notice that. I was going through Joey’s explanation after I had the same question.Thanks for responding though!