Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

Matías Moretti, Lorenzo Pandolfi, German Villegas Bauer, Sergio Schmukler and Tomas Williams

No 2024/227, IMF Working Papers from International Monetary Fund

Abstract: We present evidence of inelastic demand for risky sovereign bonds and explore its implications for optimal government debt policies. Using monthly changes in the composition of a major international bond index, we identify flow shocks unrelated to fundamentals that shift the available bond supply. From these shocks, we estimate an inverse demand elasticity of -0.30 and show that it increases with countries’ default risk. We formulate a sovereign debt model with endogenous default and inelastic investors, calibrated to our empirical estimates. By penalizing additional borrowing, an inelastic demand acts as a disciplining device that reduces default risk and bond spreads.

Keywords: inelastic financial markets; institutional investors; international capital markets; sovereign debt; IMF working paper research Department; debt issuance; price reaction; convenience yield; default cost parameter; long-term debt; U.S. dollar; bond payoff; investor demand; bond characteristics-month; inelastic investor; bond price change; unit price; price movement; Bonds; Asset prices; Demand elasticity; Debt default; Sovereign bonds; Global (search for similar items in EconPapers)
Pages: 64
Date: 2024-11-01
New Economics Papers: this item is included in nep-dge, nep-fmk and nep-opm
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Working Paper: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds (2024)
Working Paper: Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds (2024)
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