The Impact of Equity Tail Risk on Bond Risk Premia: Evidence of Flight-to-Safety from the U.S. Markets

Abstract

This paper quantifies the effects of equity tail risk on the US government bond market. We estimate equity tail risk as the option-implied stock market volatility that stems from large negative jumps as in Bollerslev, Todorov and Xu (2015), and assess its value in reduced-form predictive regressions for Treasury returns and an affine term structure model for interest rates. We document that the left tail volatility of the stock market significantly predicts one-month-ahead excess returns on Treasuries both in- and out-of-sample. The incremental value of employing equity tail risk as a return forecasting factor can be of economic importance for a mean-variance investor trading bonds. The estimated term structure model shows that equity tail risk is priced in the US government bond market. Consistent with the theory of flight-to-safety, we find that (i) Treasury prices increase and (ii) funds flow from equities into bonds when the perception of tail risk is higher. Our results concerning the predictive power and pricing of equity tail risk extend to major government bond markets in Europe.