Understanding default risk premia on public debt

Abstract

We model the pricing of public debt in a quantitative macroeconomic model with government default risk. Default occurs if a shift in the state of the economy leads to a build-up of debt that exceeds the government's ability to repay. Investors are unwilling to engage in a Ponzi game and withdraw lending in this case and thus force default at an endogenously determined fractional repayment rate. Interest rates on government bonds reflect expectations of this event. There may exist multiple bond prices compatible with a rational expectations equilibrium. At high debt-to-output ratios, small changes in fundamentals lead to steeply rising risk premia. Key determinants of the level of indebtedness at which this occurs are the perceived amount of aggregate risk, the feasibility of revenue maximizing tax rates, and the maturity of bonds.