Default Risk and the Pricing of U.S. Sovereign Bonds
68 Pages Posted: 13 Jun 2018 Last revised: 30 Jan 2019
Date Written: January 27, 2019
United States Treasury securities are traditionally viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can always be repaid by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to embed lower rate of recovery in case of default. We examine the relative pricing of nominal and inflation-indexed debt in the presence of risk of default. We show empirically that the breakeven inflation between nominal Treasury securities and TIPS is significantly related to the premium paid on U.S. credit default swaps (CDS), controlling for measures of liquidity and slow-moving capital. This evidence motivates us to model the prices of nominal and inflation-protected securities in a no-arbitrage setting. Our model shows that breakeven inflation is related to perceptions of differing rates of recovery in the two markets. The estimated model provides evidence that most of the TIPS mispricing after the crisis can be attributed to the exposure to default risk.
Keywords: Treasury, TIPS, Breakeven Inflation, Default risk, Recovery rates
JEL Classification: E4, E6, G12
Suggested Citation: Suggested Citation