How Does the Treasury Manufacture Risk-Free Debt? The Trade-Off between Insurance of Bondholders and Taxpayers

How Does the Treasury Manufacture Risk-Free Debt? The Trade-Off between Insurance of Bondholders and Taxpayers

By Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh, Mindy Z. Xiaolan
July 2020Working Paper No. 3882

When debt is priced fairly, governments face a trade-off between insuring bondholders and taxpayers. If the government decides to fully insure bondholders by manufacturing risk-free debt, then it cannot insure taxpayers against permanent macro-economic shocks over long horizons. Instead, taxpayers will pay more in taxes in bad times. Conversely, if the government insures taxpayers against adverse macro shocks, then the debt becomes at least as risky as un-levered equity. Only when government debt earns convenience yields, may governments be able to insure both bondholders and taxpayers, and then only if the convenience yields are sufficiently counter-cyclical.