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Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

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We present evidence of inelastic demand in the market for risky sovereign bonds and examine how it affects government policies. We exploit monthly changes in the composition of a major emerging market bond index to identify flow shocks that shift the available bond supply, which are unrelated to country fundamentals. Our estimates imply an average inverse price demand elasticity of -0.30, higher in magnitude than estimates for advanced economies. This elasticity increases with default risk, suggesting that investors demand a premium as compensation for risk. We develop a sovereign debt model with endogenous default, and we discipline it based on our empirical estimates. Under inelastic investors, an additional unit of debt lowers bond prices even under constant default risk. Because governments internalize this effect, the inelastic demand becomes a commitment device that limits debt issuances. Our quantitative model shows that this mechanism significantly reduces default risk and bond spreads.

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  • Matías Moretti & Lorenzo Pandolfi & Sergio L. Schmukler & Germán Villegas Bauer & Tomás Williams, 2024. "Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds," CSEF Working Papers 713, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 01 Oct 2024.
    • Handle: RePEc:sef:csefwp:713
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    More about this item

    Keywords

    einelastic financial markets; institutional investors; international capital markets; sovereign debt;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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