Convenient but risky government bonds

How does convenience yield interact with sovereign risk and the supply of government bonds? We propose a model of sovereign debt and default in which convenience yield arises because investors are able to pledge government bonds as collateral on financial markets. Consistent with euro area data convenience yield is large if government bonds are (i) scarce due to investors’ high collateral valuation or (ii) safe due to a small collateral haircut being applied to them. Calibrating the model to the data, we demonstrate that convenience yield improves the fit of sovereign default models to developed economy bond market data, contributes substantially to the public debt-to-GDP ratio, and rationalises prolonged periods of negative bond spreads – even in the presence of default risk. A large debt elasticity of investors’ collateral valuation is key to these results. In this setting, highly debt-elastic collateral haircuts exacerbate collateral scarcity in crisis times, raising government bond prices and eroding fiscal discipline.