Notes on Bonds: Liquidity at all Costs in the Great Recession

The financial crisis saw a large premium paid for Treasury notes over bonds, reaching six percent of face value. We relate this premium to the underlying sources of liquidity supply and demand. On the supply side, we find that arbitrageurs faced low direct costs but high frictions, and that the largest premium coincided with a high price charged by market makers to carry new positions. On the demand side, we find that those investors in more distress or with more active trading strategies demanded the notes relatively more as the premium grew.