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The Effect of Tail Risk on Government Bond Liquidity


Thursday, February 27, 2020
Stock image of a financial analysis chart

The fact that interest rates on government bonds fell during the financial crisis wasn’t surprising. The fact that they haven’t rebounded during the subsequent recovery may be.

In the third part of an Economic Synopses essay series, Economist Julian Kozlowski examined how the increase in tail risk—or the risk that the economy will suffer extreme negative shocks—may be playing a role in continued low interest rates on government bonds.

Kozlowski focused on two key attributes of government bonds:

  • Safety: The default risk of U.S. government bonds is nearly zero.
  • Liquidity: U.S. government bonds can be sold prior to maturity with nearly no discount.

Liquidity

Liquidity becomes especially important during periods of financial distress. The liquidity of many other assets falls during these periods, making government bonds more valuable, Kozlowski explained.

Liquidity can also be important to guard against the perception that a risky event will happen. He noted that the perceived probability of such an event—in this case, a period of financial distress—increased substantially following the Great Recession.

“The increase in tail risk implies that the liquidity of government bonds is even more valuable after the Great Recession,” Kozlowski wrote. “Consequently, the increase in liquidity needs caused an increase in the price and a decrease in the return of govern­ment bonds after the Financial Crisis.”

Measuring Tail Risk’s Impact

In a recent working paper, Kozlowski and co-authors Laura Veldkamp and Venky Venkateswaran constructed a model to measure the impact of the change in tail risk on government bonds’ liquidity and return.Kozlowski, Julian; Veldkamp, Laura; and Venkateswaran, Venky. “The Tail that Keeps the Riskless Rate Low.” NBER Working Paper No. 24362, February 2018. Their model showed that the risk-free rate never quite recovers from the negative shocks of the Great Recession.

Notes and References

1 Kozlowski, Julian; Veldkamp, Laura; and Venkateswaran, Venky. “The Tail that Keeps the Riskless Rate Low.” NBER Working Paper No. 24362, February 2018.

Additional Resources

Posted In Financial  |  Tagged julian kozlowskitail riskgreat recessionliquiditysafetygovernment bondsdefault