Inelastic Demand Meets Optimal Supply of Risky Sovereign Bonds

We present evidence of inelastic demand in the market for risky sovereign bonds and examine its interplay with government policies. Our methodology combines bond-level evidence with a structural model featuring endogenous bond issuances and default risk. Empirically, we exploit monthly changes in the composition of a major bond index to identify flow shocks that shift the available bond supply and are unrelated to country fundamentals. We find that a 1 percentage point reduction in the available supply increases bond prices by 33 basis points. Although exogenous, these shocks might influence government policies and expected bond payoffs. We identify a structural demand elasticity by feeding the estimated price reactions into a sovereign debt model that allows us to isolate endogenous government responses. We find that these responses account for a third of the estimated price reactions. By penalizing additional borrowing, inelastic demand acts as a commitment device that reduces default risk.