Research

This paper investigates the role of convenience yields in determining the yield sensitivity of the foreign demand for US Treasuries and the equilibrium interest rates of government bonds. I build a portfolio choice model featuring an investor with standard mean-variance preferences (banks), and another that derives a convenience yield from holding US Treasuries (insurances). The model can explain why insurances hold US Treasuries even if they offer negative excess returns and poor hedging properties against income risk. In the model, convenience yield preferences raise the optimal US Treasury portfolio share, and reduce its sensitivity to excess returns for a given level of risk aversion. In equilibrium, excess returns for Treasuries are lower, and decrease more strongly in response to an increase in foreign debt supply. Structural parameters recovered from an estimation of the model on data from European banks and insurances reveal that the convenience yields reduce the return sensitivity of insurances by 60%. It also explains 50% of the difference in the sensitivity to excess returns across sectors. However, it accounts for only 2% of the decline in Treasury excess returns in response to an increase in eurozone debt supply.

The fiscal sustainability of US public debt depends crucially on the convenience yield, the premium that investors pay to hold US Treasuries. Theoretically, equilibrium government debt supply is negatively associated with the convenience yield, which is also linked to the exchange rate through interest parity. However, the existing literature offers only correlational evidence, disregarding the active choice of debt issuance by the government. Using a simple open-economy model with optimal debt supply and liquidity preference for Treasuries, we show that outward shifts in debt supply reduce the convenience yield through dollar depreciation. Conversely, changes in liquidity preference generate positive comovements between debt supply, currency appreciation, and convenience yields. As a result, estimation strategies, like OLS, that fail to disentangle Treasury supply and demand shocks result in an understatement of the yield elasticity of Treasury demand, and of the impact of Treasury supply shocks on exchange rates. We confirm the predicions of our model via local projections using an instrument based on Treasury futures price changes following auction announcements. An unexpected rise in US Treasury supply lowers the convenience yield and depreciates the dollar against G10 currencies by up to three times more than previously esimated.

This paper investigates the sensitivity of the demand for safe government debt to currency unhedged and hedged excess returns in a sample of US mutual funds. We find evidence of active rebalancing towards government bonds that offer relatively higher returns on an unhedged basis, in particular euro-denominated securities. The size of the effect is large, leading to a change in portfolio share by around one percentage point on average in response to a change by one percentage point in the currency-specific excess return. Interestingly, mutual funds rebalance their portfolio towards currencies, such as the Japanese yen, that display large deviations in the covered interest parity and offer higher returns than US Treasuries on an hedged basis. Finally, when global financial risk is on the rise, US mutual fund managers repatriate their investments towards US government debt securities, mainly at the expenses of euro-denominated ones. Our results  imply that deviations in pricing conditions like uncovered and covered interest parity for sovereign bonds affect capital flows from the United States towards other major currency areas.