Bond Convenience Yields in the Eurozone Currency Union

Abstract

We develop a fiscal theory of bond convenience yields in a currency union. As exchange rates and interest rates are set at the union level and cannot respond to country-level fiscal shocks, the intertemporal government budget constraint requires bond convenience yields and default spreads to adjust in response to country-level fiscal shocks. Empirically, we show that convenience yields explain a large fraction of the variation in Eurozone government bond yields, and higher convenience yields correspond to stronger fiscal conditions. As these convenience yields generate non-trivial seigniorage revenue from debt issuance, our estimate implies economically large fiscal burden on peripheral countries relative to central countries.

Keywords: bond pricing, fiscal policy, convenience yield, currency union