Default Risk and the Pricing of U.S. Sovereign Bonds
62 Pages Posted: 13 Jun 2018 Last revised: 9 Jan 2019
Date Written: May 26, 2018
United States Treasury securities are often viewed in academics and practice as being free of default risk. In principle, nominal outstanding Treasury debt can be inflated away by issuing fiat currency. The same does not hold true, however, for inflation-indexed debt. This leads the latter to be more exposed to 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 rate 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 can simultaneously capture variation in breakeven inflation rates and U.S. Treasury CDS spreads.
Keywords: Treasury, TIPS, Breakeven Inflation
JEL Classification: E4, E6, G12
Suggested Citation: Suggested Citation