As part of the series of the "Finance Research Seminar", VGSF welcomes Lukas Schmid from the Duke University, Fuqua School of Business to present his research paper.
The Risks of Safe Assets
US government bonds exhibit characteristics often attributed to safe assets. A long literature documents significant convenience yields in scarce US Treasuries, suggesting that rising Treasury supply and government debt comes with a declining liquidity premium. We empirically document and theoretically identify a novel fiscal cost through a dual role for government debt. Through a liquidity channel an increase in government debt improves liquidity and lowers liquidity premia by facilitating debt rollover, thereby reducing credit spreads. Through an uncertainty channel, rising government debt creates policy uncertainty, raising default risk premia. We interpret and quantitatively evaluate these two channels through the lens of a general equilibrium asset pricing model with liquidity and credit risk with a rich fiscal sector. The calibrated model generates quantitatively realistic liquidity spreads and default risk premia, and suggests that rising government debt reduces liquidity premia, but crowds out corporate debt financing and investment, and creates endogenous tax volatility, reflected in higher credit spreads, risk premia, and consumption volatility. Our model implies that these effects are exacerbated in times of fiscal stress. Therefore, increasing safe asset supply can be risky, and come at a significant fiscal cost.