Yield spreads on EMU government bonds

Abstract

We provide evidence that the movements in yield differentials between euro zone government bonds explained by changes in international risk factors -as measured by banking and corporate risk premiums in the United States -are more pronounced for bonds issued by Italy and Spain. Liquidity factors play a smaller role, so policies meant to increase financial market efficiency do not appear sufficient to deliver a 'seamless' bond market in the euro area. The risk of default is a small but important component of yield differentials movements, which signal market perceptions of fiscal vulnerability, impose market discipline on national fiscal policies, and may be reduced only by further convergence in debt ratios.

The European Bond Markets under EMU

“…This is evident from Figure 4, but it is formally confirmed by the statistical evidence reported in Codogno, Favero and Missale (2003), and Geyer, Kossmeyer and Pichler (2004). This comovement implies that yield spread risk cannot be fully hedged by holding a diversified portfolio of euro-area bonds, and begs the question of what generates such comovement.…”

“…21 The relevance of sovereign default risk is further supported by credit default swap (CDS) data, available for most EMU countries since 2001. As documented by Codogno, Favero, and Missale (2003) for 2002, CDSs were priced between close to 0 basis points (for France) to more than 12 basis points (for Italy) relative to Germany, suggesting that markets perceived and priced the possibility of a default for at least some Euro zone countries (this evidence should not be overstated, as the market for CDSs is fairly thin and market prices therefore are noisy).…”

“…The studies by Codogno, Favero and Missale (2003) and Favero, Pagano and von Thadden (2004) address this problem, by using richer data to measure liquidity, including data on bid-ask spreads in the EMU government bond market. Furthermore, these studies are more explicit in the search for relevant risk factors, by including specific international and domestic factors in their regressions.…”

“…Using monthly data, Codogno, Favero and Missale (2003) proxy the country-specific risk factor by national debt to GDP ratios (noting that other variables do not add explanatory power) and international risk factors by US bond yield spreads. 25 Similarly to Geyer, Kossmeier and Pichler (2004), they find that the domestic risk factor is irrelevant, except for the case of Austria, Italy and Spain.…”

Sovereign Bond Market Integration: The Euro, Trading Platforms and Financial Crises

“…4 Indeed, recently one has observed a remarkable increase in spreads of EMU countries relative to Germany. 5 In fact, fundamental risk factors are found to matter in EMU (Beber, Brandt, and Kavajecz (forthcoming), Hallerberg and Wolff (2008)) as well as in Germany (Heppke-Falk and Wolff 2008) while the importance of liquidity factors has declined with EMU (Codogno, Favero, and Missale (2003), Pagano and von Thadden (2004), Gómez-Puig (2006)). However Favero, Pagano, and von Thadden (2008) demonstrate, that EMU bond yield spreads are affected by an aggregated risk factor and the interaction of this risk factor and liquidity differentials between the considered bonds.…”