The Risks of Safe Assets

US government bonds exhibit many characteristics often attributed to safe assets: They are very liquid and lenders readily accept them as collateral. Indeed, a growing literature documents significant convenience yields, perhaps due to liquidity, in scarce US Treasuries, suggesting that rising Treasury supply and government debt comes with a declining liquidity premium and a fall in firms' relative cost of debt financing. In this paper, we empirically document a dual role for government debt. Through a liquidity channel, an increase in government debt improves liquidity and lowers liquidity premia by facilitating debt rollover, thereby reducing credit spreads. Through an uncertainty channel, however, rising government debt creates policy uncertainty, raising credit spreads and default risk premia. We interpret and quantitatively evaluate these two channels through the lens of a general equilibrium asset pricing model with risk-sensitive agents subject to liquidity shocks, in which firms issue defaultable bonds and the government issues tax-financed bonds that endogenously enjoy liquidity benefits. The calibrated model generates quantitatively realistic liquidity spreads and default risk premia, in line with historical US debt policies and low corporate default rates. Quantitatively, our model suggests that while rising government debt reduces liquidity spreads, it not only crowds out corporate debt financing, and therefore, investment, but also creates uncertainty reflected in endogenous tax volatility, credit spreads, and risk premia, and ultimately consumption volatility. Therefore, increasing safe asset supply can be risky.