Does the US Government Hedge against Fiscal Risk?

We develop a method for measuring the amount of insurance the portfolio of government liabilities provides against fiscal shocks, and apply it to postwar US data. We define fiscal shocks as surprises in defense spending. Our results indicate that the US federal government is partially hedged against wars and other surprise increases in defense expenditures. Seven percent of the total cost of defense spending shocks in the postwar era was absorbed by lower real returns on the federal government's outstanding liabilities. More than half of this is due to reductions in expected future, rather than contemporaneous, holding returns on government debt. This implies that changes in US government's fiscal position help predict future bond returns. Our results also have implications for active management of government debt.