Abstract: We show that bond risk premia rise with uncertainty about expected inflation and fall with uncertainty about expected growth; the magnitude of return predictability using these uncertainty measures is similar to that by multiple yields Motivated by this evidence, we develop and estimate a long-run risks model with timevarying volatilities of expected growth and inflation The model simultaneously accounts for bond return predictability and violations of uncovered interest parity in currency markets We find that preference for early resolution of uncertainty, time-varying volatilities, and non-neutral effects of inflation on growth are important to account for these aspects of asset markets The Author 2012 Published by Oxford University Press on behalf of The Society for Financial Studies All rights reserved For Permissions, please e-mail: journalspermissions@oupcom, Oxford University Press

Abstract: The paper analyses the global spillovers of the Federal Reserve's unconventional monetary policy measures. First, we find that Fed measures in the early phase of the crisis (QE1), but not since 2010 (QE2), were highly effective in lowering sovereign yields and raising equity markets in the US and globally across 65 countries. Yet Fed policies functioned in a procyclical manner for capital flows to emerging markets (EMEs) and a counter-cyclical way for the US, triggering a portfolio rebalancing across countries out of EMEs into US equity and bond funds under QE1, and in the opposite direction under QE2. Second, the impact of Fed operations, such as Treasury and MBS purchases, on portfolio allocations and asset prices dwarfed those of Fed announcements, underlining the importance of the market repair and liquidity functions of Fed policies. Third, we find no evidence that FX or capital account policies helped countries shield themselves from these US policy spillovers, but rather that responses to Fed policies are related to country risk. The results thus illustrate how US unconventional measures have contributed to portfolio reallocation as well as a re-pricing of risk in global financial markets.

Abstract: Previous research has emphasized the portfolio balance effects of Federal Reserve bond purchases, in which a reduced bond supply lowers term premia. In contrast, we find that such purchases have important signaling effects that lower expected future short-term interest rates. Our evidence comes from a model-free analysis and from dynamic term structure models that decompose declines in yields following Fed announcements into changes in risk premia and expected short rates. To overcome problems in measuring term premia, we consider bias-corrected model estimation and restricted risk price estimation. In comparison with other studies, our estimates of signaling effects are larger in magnitude and statistical significance.

Abstract: The financial crisis of 2007-9 has sparked keen interest in models of financial frictions and their impact on macro activity. Most models share the feature that borrowers suffer a contraction in the quantity of credit. However, the evidence suggests that although bank lending to firms declines during the crisis, bond financing actually increases to make up much of the gap. This paper reviews both aggregate and micro level data and highlights the shift in the composition of credit between loans and bonds. Motivated by the evidence, we formulate a model of direct and intermediated credit that captures the key stylized facts. In our model, the impact on real activity comes from the spike in risk premiums, rather than contraction in the total quantity of credit.

Abstract: We present a model of sovereign debt in which, contrary to conventional wisdom, government defaults are costly because they destroy the balance sheets of domestic banks. In our model, better financial institutions allow banks to be more leveraged, thereby making them more vulnerable to sovereign defaults. Our predictions: government defaults should lead to declines in private credit, and these declines should be larger in countries where financial institutions are more developed and banks hold more government bonds. In these same countries, government defaults should be less likely. Using a large panel of countries, we find evidence consistent with these predictions.

Abstract: Previous research has emphasized the portfolio balance effects of Federal Reserve bond purchases, in which a reduced bond supply lowers term premia. In contrast, we find that such purchases have important signaling effects that lower expected future shortterm interest rates. Our evidence comes from a model-free analysis and from dynamic term structure models that decompose declines in yields following Fed announcements into changes in risk premia and expected short rates. To overcome problems in measuring term premia, we consider bias-corrected model estimation and restricted risk price estimation. We also characterize the estimation uncertainty regarding the relative importance of the signaling and portfolio balance channels.

Abstract: This paper investigates contagion between bank risk and sovereign risk in Europe over the period 2006-2011. Since this period covers various stages of the banking and sovereign crisis, it oers a fertile ground to analyze bank/sovereign risk spillovers. We de…ne contagion as excess correlation, i.e. correlation between banks and sovereigns over and above what is explained by common factors, using CDS spreads at the bank and at the sovereign level. Moreover, we investigate the determinants of contagion by analyzing bank-speci…c as well as country-speci…c variables and their interaction. We provide empirical evidence that various contagion channels are at work, including a strong home bias in bank bond portfolios, using the EBA's disclosure of sovereign exposures of banks. We …nd that banks with a weak capital and/or funding position are particularly vulnerable to risk spillovers. At the country level, the debt ratio is the most important driver of contagion.

Abstract: The downside risk CAPM (DR-CAPM) can price the cross section of currency returns. The market-beta differential between high and low interest rate currencies is higher conditional on bad market returns, when the market price of risk is also high, than it is conditional on good market returns. Correctly accounting for this variation is crucial for the empirical performance of the model. The DR-CAPM can jointly explain the cross section of equity, commodity, sovereign bond and currency returns, thus offering a unified risk view of these asset classes. In contrast, popular models that have been developed for a specific asset class fail to jointly price other asset classes.

Abstract: Reaching-for-yield — investors’ propensity to buy riskier assets in order to achieve higher yields—is believed to be an important factor contributing to the credit cycle. This paper presents a detailed study of this phenomenon in the corporate bond market. We show that insurance companies, the largest institutional holders of corporate bonds, reach for yield in choosing their investments. Consistent with lower rated bonds bearing higher capital requirement, insurance firms’ prefer to hold higher rated bonds. However, conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. Reaching-for-yield exists both in the primary and the secondary market, and is robust to a series of bond and issuer controls, including bond liquidity and duration, and issuer fixed effects. This behavior is related to the business cycle, being most pronounced during economic expansions. It is also more pronounced for firms with poor corporate governance and for which the regulatory capital requirement is more binding. A comparison of the ex-post performance of bonds acquired by insurance companies shows no outperformance, but higher systematic risk and volatility.

Abstract: Prior research shows that firms’ financial statement comparability improves the accuracy of market participants’ valuation judgments and thus may reduce firms’ costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody’s adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) to non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants’ uncertainty about and pricing of firms’ credit risk.

Abstract: We investigate the effect of government share ownership on the cost of corporate debt. Government ownership could carry an implicit debt guarantee reducing the chance of default and leading to a lower cost of debt. On the other hand, government ownership could lead to a higher cost of debt if this guarantee increases moral hazard for managers and if state owners impose social and political goals that reduce corporate profitability. Using a sample of 5,048 bond credit spreads from 43 countries over 1991-2010, we find that government ownership is associated with a higher cost of debt in non-crisis years (61 basis points (bp)) but with a lower cost of debt during the recent financial crisis (18 bp) and other banking crises (9 bp). We further show that the cost of debt associated with government ownership generally decreases as the size of the government stake increases. The impact of government ownership is stronger for non-investment-grade bonds and for bonds associated with highly-levered firms. Additionally, we document that the effect of government ownership differs by type of government entity; for instance, lower spreads are more often associated with central governments, and higher spreads with sovereign wealth funds. Finally, domestic government ownership is linked to a decrease in debt pricing, while foreign government ownership is tied to an increase. Our results indicate that government ownership generally leads to a higher cost of debt, consistent with investment distortion fostered by state influence, but in times of economic recession or firm distress, the dominant effect is a reduction in perceived default risk due to implicit government guarantees.

Abstract: Reaching-for-yield--investors' propensity to buy riskier assets in order to achieve higher yields--is believed to be an important factor contributing to the credit cycle. This paper presents a detailed study of this phenomenon in the corporate bond market. We show that insurance companies, the largest institutional holders of corporate bonds, reach for yield in choosing their investments. Consistent with lower rated bonds bearing higher capital requirement, insurance firms' prefer to hold higher rated bonds. However, conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds. Reaching-for-yield exists both in the primary and the secondary market, and is robust to a series of bond and issuer controls, including bond liquidity and duration, and issuer fixed effects. This behavior is related to the business cycle, being most pronounced during economic expansions. It is also more pronounced for firms with poor corporate governance and for which regulatory capital requirement is more binding. A comparison of the ex-post performance of bonds acquired by insurance companies shows no outperformance, but higher systematic risk and volatility.

Abstract: We investigate the political determinants of risk premiums which sub-national governments in Switzerland have to pay for their sovereign bond emissions. For this purpose we make use of financial market data from 288 tradable cantonal bonds in the period from 1981 to 2007.Our main focus is on two different political influences. First, many of the Swiss cantons have adopted very strong fiscal rules. We find evidence that both the presence and the strength of these fiscal rules contribute significantly to lower cantonal bond spreads. Second, we study the impact of a credible no-bailout regime on the risk premia of potential guarantors. We make use of the Leukerbad court decision in July 2003 which relieved the cantons from backing municipalities in financial distress, thus leading to a fully credible no-bailout regime. Our results show that this break lead to a reduction of cantonal risk premia by about 25 basis points. Moreover, it cut the link between cantonal risk premia and the financial situation of the municipalities in its canton which existed before. This demonstrates that a not fully credible no-bailout commitment can entail high costs for the potential guarantor.

Abstract: Recurrent intervals of inattention to the stock market are optimal if consumers incur a utility cost to observe asset values. When consumers observe the value of their wealth, they decide whether to transfer funds between a transactions account from which consumption must be financed and an investment portfolio of equity and riskless bonds. Transfers of funds are subject to a transactions cost that reduces wealth and consists of two components: one is proportional to the amount of assets transferred, and the other is a fixed resource cost. Because it is costly to transfer funds, the consumer may choose not to transfer any funds on a particular observation date. In general, the optimal adjustment rule—including the size and direction of transfers, and the time of the next observation—is state-dependent. Surprisingly, unless the fixed resource cost of transferring funds is large, the consumer’s optimal behavior eventually evolves to a situation with a purely time-dependent rule with a constant interval of time between observations. This interval of time can be substantial even for tiny observation costs. When this situation is attained, the standard consumption Euler equation holds between observation dates if the consumer is sufficiently risk averse.

Abstract: We examine the association between real earnings management and the cost of new bond issues of U.S. corporations. We consider three types of real earnings management: sales manipulation, overproduction, and the abnormal reduction of discretionary expenditures. We find that overproduction impairs credit ratings and that sales manipulation and overproduction are associated with higher bond yield spreads. Overall, our results imply that credit rating agencies and bondholders perceive real earnings management as a credit risk-increasing factor and thus require high risk premiums.

Abstract: How do monetary policy rules, monetary policy uncertainty, and macroeconomic shocks affect the risk properties of US Treasury bonds? The exposure of US Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average over the period 1960-2011, it was unusually high in the 1980s, and negative in the 2000s, a period during which Treasury bonds enabled investors to hedge macroeconomic risks. This paper develops a New Keynesian macroeconomic model with habit formation preferences that prices both bonds and stocks. The model attributes the increase in bond risks in the 1980s to a shift towards strongly anti-inflationary monetary policy, while the decrease in bond risks after 2000 is attributed to a renewed focus on output fluctuations, and a shift from transitory to persistent monetary policy shocks. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.

Abstract: We find that bondholders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk. While bond credit spreads are sensitive to risk for most financial institutions, credit spreads lack risk sensitivity for the largest institutions. This expectation of public support constitutes a subsidy to large financial institutions, allowing them to borrow at government-subsidized rates. The implicit subsidy provided large institutions an annual funding cost advantage of approximately 28 basis points on average over the 1990-2010 period, peaking at more than 120 basis points in 2009. The total value of the subsidy amounted to about $20 billion per year, topping $100 billion in 2009. Passage of Dodd-Frank did not eliminate expectations of government support. The cost of this implicit insurance could be internalized by imposing a corrective tax. Requiring financial institutions to shoulder the full cost of their debt would help create a more stable and efficient financial system.

Abstract: We introduce a new, market-based and forward looking measure of political risk derived from the yield spread between a country’s U.S. dollar debt and an equivalent U.S. Treasury bond. We explain the variation in these sovereign spreads with four factors: global economic conditions, country-specific economic factors, liquidity of the country’s bond, and political risk. We then extract the part of the sovereign spread that is due to political risk, making use of political risk ratings. In addition, we provide new evidence that these political risk ratings are predictive, on average, of future risk realizations using data on political risk claims as well as a novel textual-based database of risk realizations. Our political risk spread measure does not make the mistake of double counting systematic risk in the evaluation of international investments as some conventional measures do. Furthermore, we show how to construct political risk spreads for countries that do not have sovereign bond data. Finally, we link our political risk spreads to foreign direct investment. We show that a one percent point reduction in the political risk spread is associated with a 12 percent increase in net-inflows of foreign direct investment.

Abstract: Financial innovation through the creation of new markets and securities impacts related markets as well, changing their efficiency, quality (pricing error) and liquidity. The credit default swap (CDS) market was undoubtedly one of the salient new markets of the past decade. In this paper we examine whether the advent of CDS trading was beneficial to the underlying secondary market for corporate bonds. We employ econometric specifications that account for information across CDS, bond, equity, and volatility markets. We also develop a novel methodology to utilize all observations in our data set even when continuous daily trading is not evidenced, because bonds trade much less frequently than equities. Using an extensive sample of CDS and bond trades over 2002-2008, we find that the advent of CDS was largely detrimental – bond markets became less efficient, evidenced no reduction in pricing errors, and experienced no improvement in liquidity. These findings are robust to various slices of the data set and specifications of our tests.

Abstract: We derive new estimates of total wealth, the returns on total wealth, and the wealth effect on consumption. We estimate the prices of aggregate risk from bond yields and stock returns using a no-arbitrage model. Using these risk prices, we compute total wealth as the price of a claim to aggregate consumption. We find that U.S. households have a surprising amount of total wealth, most of it human wealth. This wealth is much less risky than stock market wealth. Events in long-term bond markets, not stock markets, drive most total wealth fluctuations. The wealth effect on consumption is small and varies over time with real interest rates.

Abstract: At a conceptual level, the credit risk is a component of market risk. It can occur as a result of two causes: the issuing company does not want/can no longer meet its obligations; damage to the issuing company's rating, which results in lowering the price of shares in the company in question. Both of these causes are closely linked with the risk of default that is exposed when the investor invests in shares or bonds of a company.

Abstract: This paper examines whether large-scale asset purchases (LSAPs) by the Federal Reserve influenced capital flows out of the United States and into emerging market economies (EMEs) and also analyzes the degree of pass-through from long-term U.S. government bond yields to long-term EME bond yields. Using panel data from a broad array of EMEs, our empirical estimates suggest that a 10-basis-point reduction in long-term U.S. Treasury yields results in a 0.4-percentage-point increase in the foreign ownership share of emerging market debt. This, in turn, is estimated to reduce government bond yields in EMEs by approximately 1.7 basis points. Federal Reserve LSAPs, which most previous studies have found reduced ten-year U.S. Treasury yields between 60 and 110 basis points during our sample period, therefore likely contributed to U.S. outflows into EMEs and marginal reductions in longer-term EME government bond yields. These effects are qualitatively similar to conventional U.S. monetary policy easing. To assess the robustness of these estimates, we also employ event study and vector autoregression methodologies, finding broadly similar results using these methods. While these results hold in the aggregate, marginal effects vary notably across emerging market countries.