Notes on Bonds: Illiquidity Feedback During the Financial Crisis*

We trace the evolution of extreme illiquidity discounts among Treasury securities during the financial crisis, when bonds 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. * Musto and Schwarz are with the Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia PA 19104. Nini is with the LeBow College of Business, Drexel University, 3141 Chestnut Street, Philadelphia PA 19104. David Musto, (215) 898-2323, [email protected]; Greg Nini, (215) 571-4596, [email protected]; Krista Schwarz, (215) 8986087, [email protected]. We are grateful to the Dean’s Research Fund of the Wharton School and WRDS for data funding. We thank Pierre Collin-Dufresne, Michael Fleming, Jeremy Graveline, Josephine Smith and commenters at numerous presentations for their very helpful comments. We are grateful to Michael Bulboff for outstanding research assistance. All remaining errors are our own.