On portfolio frictions, asset returns and volatility

We rationalize the observed short-run differences in corporate and long-term government bond yields in an financial-accelerator model with frictions that restrict changes in portfolio shares. We estimate the model on quarterly data for the Euro Area from 1999 to 2019, and show that the portfolio friction parameter is positive and significant. Portfolio frictions not only generate a time-varying wedge between the two returns that fits the data, but also raisethe volatility of return differentials, and the precautionary motive of savers. As a result, the macroeconomic effects of uncertainty shocks are amplified by portfolio frictions.