Bond Supply and Excess Bond Returns

Abstract

We examine empirically how the maturity structure of government debt affects bond yields and excess returns. We organize our investigation around a model of preferred habitat, in which supply shocks impact an arbitrage-free term structure. Consistent with the model, we find that the relative supply of long-term bonds is positively related to bond yield spreads and excess returns, with the effects being larger for longer-maturity bonds. Moreover, supply predicts positively excess returns even after controlling for term-structure slope, and supply and slope become stronger predictors of returns following periods when arbitrageurs lose money.

Keywords: Term Structure of Interest Rates, Bond Risk Premia, Limited Arbitrage, Public Debt Management

JEL Classification: E43, G12, H63