In “The Demand for Treasury Debt,” Kellogg School of Management professors Arvind Krishnamurthy and Annette Vissing-Jørgensen relate the yield spread between AAA-rated corporate bonds and Treasury securities to the U.S. government debt-to-GDP ratio—that is, the ratio of the face value of publicly held U.S. government debt to U.S. gross domestic product (GDP). They find that the corporate bond spread is high when the stock of government debt is low while the spread is low when the stock of debt is high.
Figure 1: Corporate Bond Spread and Government Debt
The researchers believe that this negative correlation between the debt-to-GDP ratio and the corporate bond spread occurs because of variation in the “convenience yield” on Treasury securities. Investors value Treasury securities—which have convenience value—beyond the securities’ cash flows. When the stock of debt is low, the marginal convenience valuation of debt is high. Investors bid up the price of Treasuries relative to other securities, such as corporate bonds, causing the yield on Treasuries to fall further below corporate bond rate. This situation leads the bond spread to widen. The opposite applies when the stock of debt is high.
What are the sources of this convenience yield on Treasury securities? Studying disaggregated data from the Federal Reserve’s Flow of Funds Accounts, Krishnamurthy and Vissing-Jørgensen maintain that different groups of Treasury owners likely have different reasons for holding Treasuries. The three chief reasons are as follows: 1) the high liquidity of Treasuries compared to corporate bonds; 2) neutrality, which may motivate official institutions such as U.S. Federal Reserve banks, state and local governments, and foreign central banks to hold Treasuries to avoid favoring any non-governmental borrower over another; and 3) Treasuries’ widespread reputation as the lowest-risk interest-bearing asset.
The researchers then examine which groups of investors are the strongest drivers of the convenience value of Treasury securities. They find that Treasury demands of official institutions are the least sensitive to the corporate bond spread while demands of long-horizon investors—such as pension plans and insurance companies—are more sensitive. Finally, they present implications of their findings for corporate bond spreads, the financing of the U.S. deficit, the riskless interest rate, and the value of aggregate liquidity.
Among their conclusions, Krishnamurthy and Vissing-Jørgensen note that investors value Treasuries, despite their relative low return, for their liquidity and convenience. They estimate that at the current level of Treasury debt-to-GDP, the convenience yield on the Treasury debt is around 0.7 percentage points. This, in turn, means that taxpayers benefit from being able to finance the federal debt with securities that have special benefits to investors. The implied saving is around 0.3 percent of GDP per year. In fact, the annual interest expense to taxpayers from being able to finance the current level of debt with securities that have a convenience yield is about as large as the annual benefit to taxpayers resulting from the public’s willingness to hold money at no interest.
Another implication of the results is that if foreign official investors decide to quit the U.S. Treasury market (thus selling roughly 29 percent of the debt back to U.S. investors), this sell-off would raise Treasury yields relative to corporate bond yields. The researchers estimate this effect at 0.3 percentage points. In addition, long-term investors who are seeking to build retirement funds and who do not place much value on the liquidity of Treasuries would be better off investing in AAA corporate bonds rather than Treasury bonds.
Furthermore, the finding of a convenience demand for Treasury debt suggests caution against the common practice of identifying the Treasury interest rate with asset pricing models’ riskless interest rate. This has practical implications, for example, for companies estimating their cost of capital.
Krishnamurthy and Vissing-Jørgensen summarize their findings by noting that they have shown that the demand for “convenience” provided by Treasury debt depends on the yield spread, and they provide estimates of the elasticity of demand. A hypothetical rise in the debt-to-GDP ratio from its current value of 0.38 to a new value of 0.39 will decrease the spread between corporate bond yields and Treasury bond yields between 1.5 basis points (0.015 percentage points) and 4.25 basis points. Individual groups of Treasury holders have downward sloping demand curves. Even groups with the most elastic demand curves have demand curves that are far from flat. “Our results,” the analysts say, “suggest that U.S. government debt is a special asset that offers a convenience yield to investors. Our estimates imply that the value of the liquidity provided by the current level of Treasuries is between 0.21 and 0.54 percent of GDP per year.”