Market #3 · Bonds & Fixed Income

The bond market

A parallel to the goods and labor modules: the full structural specification of bond demand and supply, instrument-specific pricing equations (coupon / zero / credit / CDS / MBS / linkers), valuation methods (bootstrap, Nelson–Siegel, affine ATSM, Merton, Monte-Carlo OAS), and the risk sensitivities used to trade, hedge, and regulate fixed-income portfolios.

Market clearing in yield space

Q^{D} (y; X^{D}) = Q^{S} (y; X^{S}) \Rightarrow y^{*} (and equivalently P^{*} = f (y^{*}))

Bond markets clear in yield rather than price: primary auctions elicit demand at successive yields until the offering size clears. QE / QT, fiscal surges, flight-to-quality, and bank regulation all appear as shifts in either curve.

Demand shift (QE, HQLA, FTQ)

Supply shift (deficit, M&A wave)

Structural demand & supply

Q_{t}^{D} = f (y_{t}, r_{t}^{f}, π_{t}^{e}, σ_{t}^{y}, s_{t}, L_{t}, τ_{t}, F X_{t}, R_{t}, F_{t}, D_{t}, Q E_{t})

Q_{t}^{S} = g (G_{t}, M_{t}, I_{t}, M & A_{t}, R_{t}^{r e}, r_{t}, ρ_{t}, Cov_{t}, K_{t}, S S_{t}, G_{t}^{g r n})

Signs, data sources, and rationales for every regressor below.

Bond-demand determinants

Symbol	Variable	Data source	Sign	Economic rationale
$y$	Yield-to-maturity	TRACE, Bloomberg, MTS	+	Higher promised yield raises investor demand at auction (bid-to-cover) — the price-yield curve is downward-sloping so demand at a given price rises with yield.
$r_{f}$	Risk-free short rate	Fed H.15, ECB €STR	−	Substitute return; higher policy rate reduces demand for long duration bonds unless term premium compensates.
$π^{e}$	Expected inflation	TIPS breakevens, SPF	−	Erodes real coupons on nominal bonds; shifts demand toward TIPS / linkers.
$σ_{y}$	Rate volatility	MOVE index, swaption vols	−	Convexity is priced: high vol raises option-adjusted spread on callables, lowers demand for negative-convexity MBS.
$s$	Credit spread	OAS, CDX/iTraxx	+	Compensation for default risk; wider spreads attract yield-seeking demand once perceived risk stabilizes.
$L$	Liquidity premium	Bid-ask, Amihud illiq.	+	Illiquid bonds require extra yield; on-the-run / off-the-run spread is a classic measure (Krishnamurthy 2002).
$τ$	Tax treatment	IRS §103 (munis), OECD	±	Municipal tax exemption raises after-tax demand; capital-gains treatment matters for zero-coupon bonds.
$F X$	Currency & hedging cost	CIP basis, FX forwards	±	Foreign investors compare hedged yields; CIP deviations post-2008 alter cross-border demand.
$R$	Regulatory demand (HQLA, LCR)	Basel III, Solvency II	+	Banks/insurers required to hold sovereigns and IG bonds; structural non-price demand.
$F$	Flight-to-quality	VIX, EPU index	+	Risk-off episodes drive demand for Treasuries/Bunds even at low or negative yields.
$D$	Duration preference / ALM	Insurer & pension surveys	+	Life insurers demand long duration to match liabilities (Domanski–Shin–Sushko 2017 preferred-habitat).
$QE$	Central-bank balance-sheet demand	Fed SOMA, ECB APP/PEPP	+	QE inelastic buyer removes duration from the market (D'Amico–King 2013; Vayanos–Vila 2021).

Bond-supply determinants

Symbol	Variable	Data source	Sign	Economic rationale
$G$	Fiscal deficit / net issuance	Treasury Q. Refunding, DMO	+	Primary supply scales with the fiscal gap; auction sizes drive term-premium spikes.
$M$	Debt-management maturity mix	TBAC, ECB debt agencies	±	Shifting issuance from bills to bonds raises duration supply (Greenwood–Vayanos 2014).
$I$	Corporate investment plans	FRB Flow of Funds	+	Firms issue to fund capex; supply is procyclical in IG, countercyclical in stressed HY.
$M & A$	M&A leverage financing	Dealogic, LCD	+	Bridge-to-bond financing generates large episodic HY / leveraged loan supply.
$R^{r e}$	Refi wave / call incentive	MBS OAS, callable OAS	+	Lower rates trigger refinancing of MBS and callable IG; effective supply/duration collapses (negative convexity).
$r$	Cost of debt vs equity	WACC estimates	±	Firms optimize capital structure; higher r shifts to equity or delays issuance.
$ρ$	Credit rating pressure	S&P/Moody's/Fitch	−	Downgrade risk restrains issuance from fallen-angel candidates.
$C o v$	Covenant / documentation flexibility	Xtract, Moody's Cov-Lite	+	Loose covenants expand issuance capacity; tighter documentation reduces supply in stress.
$K$	Securitization capacity	SIFMA ABS/MBS issuance	+	Structured-product supply depends on collateral origination (autos, credit cards, prime mortgages).
$S S$	Sovereign-supranational programs	EFSF/ESM, EU NGEU	+	Supranational issuance (SSA) grew post-2020 crises; adds high-grade supply.
$G^{g r n}$	Green / social / sustainability-linked	CBI, ICMA GBP database	+	ESG label supply grew from ~$0 in 2013 to >$1T/yr by 2024; often prices at a modest greenium.