Bond Supply and Excess Bond Returns

We examine empirically how the supply and maturity structure of government debt affect bond yields and expected returns. We organize our investigation around a term-structure model in which risk-averse arbitrageurs absorb shocks to the demand and supply for bonds of different maturities. These shocks affect the term structure because they alter the price of duration risk. Consistent with the model, we find that the maturity-weighted-debt-to-GDP ratio is positively related to bond yields and future returns, controlling for the short rate. Moreover, these effects are stronger for longer-maturity bonds and following periods when arbitrageurs have lost money. We use our empirical estimates to calibrate the model. ∗We thank Malcolm Baker, Dan Bergstresser, Kobi Boudoukh, Mike Chernov, Greg Duffee, Mike Fleming, Ken Froot, Ken Garbade, Sam Hanson, Frank Keane, Arvind Krishnamurthy, Dina Marchioni, Jonathan Parker, Anna Pavlova, Christopher Polk, Andrei Shleifer, Erik Stafford, Jeremy Stein, Otto Van Hemert, Jaume Ventura, Pietro Veronesi, Jean-Luc Vila, Annette Vissing-Jorgensen, Jeff Wurgler, an anonymous referee, and seminar participants at BGI, Bank of England, Chicago Fed, CREI Pompeu Fabra, Duke, Harvard, Hebrew U., LSE, New York Fed, Northwestern, Tel-Aviv, Yale, and the Chicago “Beyond Liquidity” conference for helpful comments. We are especially grateful to John Cochrane for an extensive set of insightful comments. Sonya Lai provided excellent research assistance. Financial support from the Division of Research at the HBS and the Paul Woolley Centre at the LSE is gratefully acknowledged.