Liquidity, Reconstitution, and the Value of U.S. Treasury Strips

Abstract

An apparent pricing anomaly exists in the market for U.S. Treasury strips: zerocoupon strips created from principal payments typically trade at significantly higher prices than otherwise identical zero-coupon strips created from coupon payments. In addition to documenting this phenomenon, this study demonstrates that differences in liquidity and differences in reconstitution characteristics explain much of this price variation. U.S. TREASURY STRIPS ARE zero-coupon bonds created from either the principal or individual coupons of U.S. Treasury bonds. If the maturity date and face value are identical, the cash flows for a strip derived from a principal payment are identical to the cash flows for a strip derived from a coupon payment. However, the two instruments almost always trade at significantly different prices. For a recent sample (5/31/91), the mean percentage difference in price is greater than 1.2%, with some differences greater than 2.7%. This is an apparent anomaly, since securities with identical cash flows should trade at the same price. Although coupon strips and principal strips have identical cash flows at maturity, closer inspection reveals two differences: the two instruments have different degrees of liquidity and different reconstitution characteristics.Previous studies have documented the effect of liquidity on prices in other markets. Amihud andMendelson (1986, 1989) find that common stocks with differences in liquidity have significantly different risk-adjusted rates of return. Silber (1991) studies restricted stock offerings and documents substantial price discounts on these illiquid securities vis-a-vis identical stocks that trade in the open market.1 In a study of U.S. Treasury bills and Treasury bonds with remaining maturities of less than six months, Amihud and Mendelson (1991) find that differences in liquidity contribute to differences in prices between matched pairs of bills and bonds of the same The University of Tennessee, Department of Finance. The authors appreciate helpful comments made by an anonymous reviewer of this journal. The authors would also like to thank

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