Not risk free: The relative pricing of euro area inflation-indexed and nominal bonds

Selective default is an event in which a sovereign issuer chooses not to meet obligations on a class of bonds, while servicing her other debt. This paper presents unique empirical evidence of selective default risk premium in inflation-linked sovereign bond (ILB) yields of Germany, France and Italy. I identify this effect from the difference of breakeven rates from country pairs. Differencing controls for common components, such as the effect of inflation expectations, monetary policy or interest rate risk. I find that the remaining part in breakeven rates is explained by two systematic risk factors, liquidity and sovereign credit risks – both within and across countries. I link these findings to the ILB-nominal puzzle, which shows that ILBs are underpriced relative to nominal bonds of the same issuer. I show that this underpricing is in part due to relative risk premia differences between nominal and inflation-linked debt: ILBs are less liquid, moreover investors perceive them to have higher credit risk during the financial and euro crises. This implies an implicit seniority and a subsequent convenience yield in nominal bonds.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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