Default Risk and the Pricing of U.S. Sovereign Bonds
112 Pages Posted: 13 Jun 2018 Last revised: 3 Apr 2024
Date Written: December 22, 2023
Abstract
We examine the relative pricing of nominal Treasury bonds and Treasury inflation-protected securities (TIPS) in the presence of United States default risk. Hedged breakeven inflation (ILSBEI) is positively and significantly related to U.S. default risk, driven by correlation between shocks to default risk and both shocks to inflation swap premia and Treasury yields. To understand the mechanisms through which default risk is related to inflation swaps and sovereign yields, we estimate an affine term structure model to capture their joint dynamics. Our estimation implies that the interaction between inflation dynamics and default is the primary source of differential pricing.
Keywords: Treasury, TIPS, Breakeven Inflation, Default risk, Recovery rates
JEL Classification: E4, E6, G12
Suggested Citation: Suggested Citation