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  3. 2026
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Fixed Income

Paper Session

Saturday, Jan. 3, 2026 8:00 AM - 10:00 AM (EST)

Loews Philadelphia Hotel
Hosted By: American Finance Association
  • Yoshio Nozawa, University of Toronto

The Pre-FOMC Drift and the Secular Decline in Long-Term Interest Rates

Jun Pan
,
Shanghai Jiao Tong University
Qing Peng
,
Shanghai Jiao Tong University

Abstract

"We document positive and significant returns on long-term U.S. Treasury bonds on
the day before the FOMC announcements and attribute this pre-FOMC drift to the
premium for heightened uncertainty. Unlike the pre-FOMC drift in U.S. equity, which is realized mostly on the day of the FOMC announcement, the pre-FOMC drift in long-term bond occurs earlier. On the day before the FOMC announcement, the 10-year bond yield drops by a significant 0.68 bps and contributes importantly to the secular decline in interest rates documented by Hillenbrand (2021). Unique to the day before the FOMC is a severe disconnect between the long- and short-term yields – an indication that the pre-FOMC pricing of long-term bonds is dominated by the risk-premium channel, not the monetary-policy decision on the target rate. We further capture the pre-FOMC heightened uncertainty using the ex-ante Macro Attention Index (MAI) of Fisher et al. (2022). Conditioning on above-median MAI on unemployment rates, the pre-FOMC reduction in 10-year yield increase significantly to 1.50 bps and is predictive of the subsequent pre-FOMC drift in equity. We further find a strong and positive relation between the pre-FOMC reduction in 10-year yield and the ratio of dissent among the FOMC committee."

Monetary Policy the Yield Curve and the Repo Market

Ruggero Jappelli
,
University of Warwick
Loriana Pelizzon
,
Goethe University Frankfurt
Marti Subrahmanyam
,
New York University

Abstract

"In this paper, we propose a model that integrates the yield curve with the repo market, in which bonds serve both as investment opportunities and as collateral for loans. Preferred-habitat investors and arbitrageurs generate downward-sloping demand for bonds and upward-sloping supply of collateral in the repo market. Previous literature on the yield curve summarizes the money market by the stochastic behavior of a unique, exogenous short interest rate. Such a restriction is at odds with the growing recognition that demand and supply forces affect both the prices in the bond market and the repo rates associated with bonds in the secured money market. Our paper is a first attempt to fill this gap in the literature. The model generates two key outcomes by endogenizing arbitrageurs' demand in the repo market, which is directly tied to their supply in the cash bond market. This allows them to accommodate the bond demand from preferred-habitat investors. First, we show that the presence of bonds that are relatively costly to borrow on the repo market limits the arbitrage activity and thus hinders the transmission of bond demand on the stochastic discount factor and the slope of the yield curve. Second, the presence of relatively costly bonds to borrow creates relative price anomalies between bonds with identical cash flows. In the context of quantitative policies, these two effects result in a weaker duration extraction channel and a stronger local supply effect of asset purchases. Thus, the paper uncovers a general trade-off between the duration extraction and the local supply effects of quantitative policies. Academics and policymakers should consider the bond and the repo markets in combination with each other, since traded assets and economic agents are the same in both markets."

Upgrading Credit Pricing and Risk Assessment through Embeddings

Xavier Gabaix
,
Harvard University
Ralph Koijen
,
University of Chicago
Robert Richmond
,
New York University
Motohiro Yogo
,
Princeton University

Abstract

Credit ratings are central in fixed income markets, defining mutual fund benchmarks and risk-based capital regulation of insurance companies. Credit ratings explain a large share of the variation in corporate credit spreads, but a surprising amount of variation remains across firms. Asset pricing theory implies that equilibrium bond prices depend not only on credit ratings but all information that investors use to form their portfolios. We extract a high dimensional representation of this information, called firm embeddings, from US corporate bond holdings of mutual funds and insurance companies. Within broad credit rating categories, firm embeddings explain credit spreads and the volatility of credit spreads better than credit ratings and the distance to default. Therefore, firm embeddings can augment (and eventually replace) credit ratings to provide more timely and accurate information for fixed income markets. We illustrate the potential impact of an improved rating system on the risk-based capital regulation of insurance companies.

A Preferred-Habitat Model with a Corporate Sector

Filippo Cavaleri
,
University of Chicago

Abstract

I study the interplay of interest rate risk, credit risk, and bond quantities in a term structure model of Treasury and corporate bond yields. The core of the theory is an endogenous connection between credit and duration risk premia through bond portfolios. Shocks to default probabilities propagate to Treasury yields through their impact on the price of interest rate risk. The dependence of credit risk premia on interest rates affects the strength of monetary policy transmission to both long term Treasury and corporate yields. The credit and the duration risk premia amplify the effect of an in- crease in default rates on credit spreads. A decline in Treasury supply can adversely impact corporate yields by raising the price of credit risk through a safety channel. The impact of quantitative easing is asymmetric and depends on which assets are purchased.

Discussant(s)
Sebastian Hillenbrand
,
Harvard University
Aytek Malkhozov
,
McGill University
Valentin Haddad
,
University of California-Los Angeles
Monika Piazzesi
,
Stanford University
JEL Classifications
  • G1 - General Financial Markets