This paper presents empirical evidence of selective default premium in inflation-linked sovereign bond (ILB) yields of Germany, France and Italy. I define selective default as an event in which a sovereign issuer chooses not to meet obligations on a class of bonds, while servicing her other debt. To identify this effect, I use a unique cross-country sample to set up a trading strategy that takes the difference of breakeven rates from two countries. Taking the spread eliminates common components, such as the effect of inflation expectations or interest rate risk, in a difference in differences setting. As a result I find that exposures to two systematic risk factors, liquidity and credit risks account for most of the remaining yield difference. I link these findings to the ILB-nominal puzzle documented by Fleckenstein, Lustig and Longstaff (2014). By addressing the alternative explanations for the existence of the puzzle, I find that i) risk premia in the inflation swap quotes or the value of the deflation option cannot account for the magnitude of the puzzle; ii) differences in liquidity and credit risk premia in ILB and nominal bond yields explain the persistent nature of the puzzle; and iii) I find that investors perceived ILBs to have higher credit risk exposure than nominal bonds during the financial and euro crises.Not risk free: The relative pricing of euro area inflation-indexed and nominal bonds.

Discussant: Nico Dragt (VU University Amsterdam)