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This paper adopts the Constant Maturity Treasury (CMT) issuance and the Treasury Inflation Protected Securities (TIPS) to strip the general credit risk and liquidity risk of bonds. By reclassifying the reinvestment risk as a type of interest risk, we analyze the yield spread of inflation risk and interest rate risk. As TIPS is free of inflation risk, we focus on the source of its unique major risk: interest rate risk. We employ daily data and Granger causality test and Johansen cointegration test to conclude that market sentiment, measured by the Chicago volatility (VIX) series, affects the yield related to interest rate risk significantly. Such impact is persistent in all different term of maturity over 10 years. However, when inflation risk is present, market sentiment fails to dominate the yield spread.

Which Risk Dominates the Bond Yield? Empirical Tests from Market Sentiment Perspective