Bond Scarcity and the Term Structure

Title: Bond Scarcity and the Term Structure

Abstract: We develop a general quantity-driven equilibrium model that integrates the term structure of interest rates and the repo market to shed light on the effects of bond scarcity on the yield curve. In our model, investors with habitat preferences for special bonds exert price pressure in the secondary market. Arbitrageurs take the opposite side, but finance their positions by rolling over repo contracts, thus increasing the demand for the targeted securities in the repo market and lowering the rates to borrow against these bonds. We characterize in closed form the endogenous dynamic interaction between bond prices and repo rates, and illustrate both the strong localization of supply effects and the resulting portfolio rebalancing of investors. Our calibrated model can quantitatively match US Treasury data and the coexistence and dynamic interactions of general and special bonds in the yield curve. The requisite absence of arbitrage opportunities among bonds with equivalent cash flows obtains since the expected risk-return ratio accounts for the short repo rate, which varies at the instrument level.