The equity-like behaviour of sovereign bonds

Abstract

Using a rich dataset of high frequency historical information from 2004 to 2013 we study the determinants of European sovereign bond returns over calm and crisis periods.We find that the sign of the equity beta crucially depends on country risk. In low risk countries, government bonds represent a natural hedge against equity risk as the equity beta is negative regardless of market conditions. On the other hand, government bonds of high risk countries lose their "safe-asset" status and exhibit more equity-like behaviour during the sovereign debt crisis, with positive and strongly significant co-movements relative to the stock market. Our estimates indicate that the equity beta switches from negative to positive when a sovereign's credit spread rises above 2%. We find that the decoupling of the government bond market between high risk and low risk countries implies that indiscriminate portfolio diversification does not pay. Instead, "prudent diversification" appears to offer superior risk adjusted returns in periods of sovereign stress and through the economic cycle. We find that the sign of the equity beta crucially depends on country risk. In low risk countries, government bonds represent a natural hedge against equity risk as the equity beta is negative regardless of market conditions. On the other hand, government bonds of high risk countries lose their "safe-asset" status and exhibit more equity-like behaviour during the sovereign debt crisis, with positive and strongly significant co-movements relative to the stock market. Our estimates indicate that the equity beta switches from negative to positive when a sovereign's credit spread rises above 2%. We find that the decoupling of the government bond market between high risk and low risk countries implies that indiscriminate portfolio diversification does not pay. Instead, "prudent diversification" appears to offer superior risk adjusted returns in periods of sovereign stress and through the economic cycle.JEL Classification: G01, G12, G15, E43

Tracking the relationship between euro area equities and sovereign bonds

“…Based on this analysis, a positive relationship between the performance of these two instruments would be expected, which is confirmed in the short-run in the case of ES. On the contrary, the stock-bond co-movements in higher-rated jurisdictions remained negative and statistically significant, supporting the fact that, driven by the worst outlook about future economic developments, investors fled stock and sovereign bond markets of vulnerable Member States looking to invest in financial assets of more solid economies (see, e.g., Dufour et al, 2017;Jammazi et al, 2015). These conclusions are supported by Panel C, since the correlation between stocks of euro area countries perceived as having lower credit quality and debt of less vulnerable economies remains negative in this subset.…”

A New Asymmetric Copula with Reversible Correlations and Its Application to the EU Sovereign Debt Crisis

“…Correlation reversal of stock-bond returns in the EU crisis was reported by Dufour et al (2017) and Ohmi and Okimoto (2016). They found that the stock-bond correlations changed signs from negative to positive during the financial crisis and remained positive even after the crisis ended.…”

Explaining repo specialness

“…Using the bonds' ISIN numbers, we match the repo market information with the bond market information. For further information on MTS intraday data, see Dufour, Stancu, and Varotto () and references therein.…”