The pricing of G7 sovereign bond spreads – The times, they are a-changin

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may AbstractAgainst the background of the current debate about fiscal sustainability in several advanced economies, this paper estimates determinants of G7 sovereign bond spreads, using high-frequency proxies for market expectations about macroeconomic fundamentals and allowing for time-varying parameters. The paper finds substantial asymmetry in the importance of country fundamentals and considerable time variations in the pricing of risks. There has been a reduced pricing of several risk factors in the years preceding the financial crisis, and either an overpricing of risk or the pricing of a re-denomination risk of euro area bonds during the European sovereign debt crisis. JEL-codes: E43, E44, F34, G15Keywords: sovereign spreads; fiscal policy; time-varying coefficients 2 Non-technical summaryA question at the heart of the current debate about the sovereign debt crisis is to which extent market prices of sovereign bonds reflect economic fundamentals in an appropriate fashion, or whether swings in risk appetite have led to an under-pricing of risk prior to the global financial crisis, and possibly to an over-pricing of risk during the sovereign debt crisis. Although the focus of the discussion currently rests on the euro area, fiscal sustainability concerns have also arisen in many other advanced economies, inside and outside Europe. Even several countries with long-standing excellent credit ratings have been affected; for instance, both the United States and France have recently lost their AAA ratings by Standard and Poors, on concerns about the governments' budget deficits and rising debt burdens. As a consequence, we need to understand better the pricing mechanisms in sovereign debt markets in advanced economies.In the current paper, we will therefore study sovereign bond spreads of the G7 countries over the last two decades. To estimate to what extent market prices reflect fundamentals, and how this has changed over time, the model employed in this paper allows for time variation in the coefficients, and stochastic volatility in the error term. As market prices are likely to reflect expectations about the evolution of fundamentals much more than past realised values, all fundamental variables used in the current paper are forward-looking. The use of Consensus Economics data allows us to have a set of expectations by market participants for all these variables for the G7 countries at a monthly frequency, covering ...

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