Default Risk and the Pricing of U.S. Sovereign Bonds

68 Pages Posted: 13 Jun 2018 Last revised: 30 Jan 2019

See all articles by Robert F. Dittmar

Robert F. Dittmar

University of Michigan, Stephen M. Ross School of Business

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Guillaume Roussellet

McGill University - Desautels Faculty of Management

Peter Simasek

Georgia Institute of Technology - Scheller College of Business

Date Written: January 27, 2019

Abstract

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

Dittmar, Robert F. and Hsu, Alex and Roussellet, Guillaume and Simasek, Peter, Default Risk and the Pricing of U.S. Sovereign Bonds (January 27, 2019). Georgia Tech Scheller College of Business Research Paper No. 18-20. Available at SSRN: https://ssrn.com/abstract=3185307 or http://dx.doi.org/10.2139/ssrn.3185307

Robert F. Dittmar (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Guillaume Roussellet

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

Peter Simasek

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

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