The safety and liquidity premium of treasury bonds over the business cycle

Swiss partners

• ETH Zürich: Hugo van Buggenum (main applicant)

Partners in the MENA region

• Qatar University: Mohammed Ait Lahcen (main applicant)

Other partners

• The University of North Carolina at Chapel Hill, Etats-Unis: Stanislav Rabinovich
• Queensland University of Technology, Etats-Unis: Pedro-Gomis Porqueras

Presentation of the projet

US Treasury securities, which are essential assets for both the US government and global financial markets due to their safety and liquidity features, typically trade at a premium. The project seeks to dissect this treasury premium into safety and liquidity components, and to analyze how these vary over the business cycle. Understanding these fluctuations is crucial for central banks in tailoring their policy responses and assessing financial stability, as well as for investors in making better forecasts and investment decisions.

The project will develop both empirical analysis and a quantitative theoretical model. For the empirical part, we will collect and analyze US macroeconomic data, Treasury bonds of different maturities, and micro-level data on  corporate bond yields, along with firms' financials. For the analysis, we measure the overall treasury premium as the yield difference between Moody's seasoned Baa (the median bond rating in the US) corporate bonds and long-term Treasury bonds. The safety and liquidity premiums are computed as the yield difference between Moody's Baa and Aaa corporate bonds for safety, and between Aaa corporate bonds and US Treasury bonds for liquidity. Preliminary findings, based on macro data, indicate that these premiums are counter-cyclical, positively related to economic uncertainty, and negatively linked to government bond supply. To gain a more disaggregated understanding of the premia over the business cycle, we plan to examine how US corporate bonds, compared to US Treasuries, relate to US firms' behavior. To do so we will combine and merge data on US firms from Compustat with Bloomberg and Moody's data on corporate bonds.

To have a deeper understanding and uncover the underlying mechanisms driving the evolution of the premia, we develop a real business cycle model with a liquidity-based demand for bonds as well as search frictions in the labor market. Among government and corporate bonds, government bonds are assumed to be nominally safe and liquid, whilst corporate bonds are less liquid and subject to endogenous default risk, leading to fluctuations in the liquidity and safety premiums when the economy experiences aggregate and firm specific shocks. The model will be calibrated to the US economy and will be simulated to generate liquidity and safety premia over the business cycle, consistent with the empirical evidence.