Bond Supply and Excess Bond Returns

Abstract

We examine empirically how the supply and maturity structure of government debt affect bond yields and expected returns. We organize our investigation around a term-structure model in which risk-averse arbitrageurs absorb shocks to the demand and supply for bonds of different maturities. These shocks affect the term structure because they alter the price of duration risk.Consistent with the model, we find that the maturity-weighted-debt-to-GDP ratio is positively related to bond yields and future returns, controlling for the short rate. Moreover, these effects are stronger for longer-maturity bonds and following periods when arbitrageurs have lost money.We use our empirical estimates to calibrate the model. * We thank Malcolm Baker, Dan Bergstresser, Kobi Boudoukh, Mike Chernov, Greg Duffee, Mike Fleming, Ken Froot, Ken Garbade, Sam Hanson, Frank Keane, Arvind Krishnamurthy, Dina Marchioni, Jonathan Parker, Anna Pavlova, Christopher Polk, Andrei Shleifer, Erik Stafford, Jeremy Stein, Otto Van Hemert, Jaume Ventura, Pietro Veronesi, Jean-Luc Vila, Annette Vissing-Jorgensen, Jeff Wurgler, an anonymous referee, and seminar participants at BGI, Bank of England, Chicago Fed, CREI Pompeu Fabra, Duke, Harvard, Hebrew U., LSE, New York Fed, Northwestern, Tel-Aviv, Yale, and the Chicago "Beyond Liquidity" conference for helpful comments. We are especially grateful to John Cochrane for an extensive set of insightful comments. Sonya Lai provided excellent research assistance. Financial support from the Division of Research at the HBS and the Paul Woolley Centre at the LSE is gratefully acknowledged.

Mortgage Risk and the Yield Curve

“…7 The role of financial institutions in our model is similar to that of Greenwood and Vayanos (2014). Fleming and Rosenberg (2008) find that Treasury dealers are compensated by high excess returns when holding large inventories of newly issued Treasury securities.…”

“…To interpret this value, we multiply it by financial institutions' wealth to obtain a coefficient of relative risk aversion. In a setting similar to ours, Greenwood and Vayanos (2014) use financial institutions' capital to GDP ratio of 13.3%. Because we use the dollar duration of the MBS index to calibrate the model and the average value of the index itself is standardized to one dollar, we also need to adjust for the size of the MBS market relative to GDP.…”

“…Thus, the net supply of bonds matters. Greenwood and Vayanos (2014) use this theoretical framework to study the implications of a change in the maturity structure of government debt supply, similar to the one undertaken in 2011 by the Federal Reserve during "Operation Twist." Our paper is different in at least three respects.…”

“…First, in our model the variation in the net supply of bonds is driven endogenously by changing MBS duration, and not exogenously by the government. Second, the supply factor in Greenwood and Vayanos (2014) explains low-frequency variation in risk premiums, because movements in maturity-weighted government debt to GDP occur at a lower frequency than do movements in the short rate.…”

“…Finally, Greenwood and Vayanos (2014) posit that the government adjusts the maturity structure of its debt in a way that stabilizes bond markets. For instance, when interest rates are high, the government will finance itself with shorter maturity debt and thereby reduce the quantity of interest rate risk held by agents.…”