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

D'Agostino, Antonello and Ehrmann, Michael (2012): The pricing of G7 sovereign bond spreads – the times, they are a-changin.

Abstract

Against the background of the current debate about fiscal sustainability in several advanced economies, this paper estimates the determinants of sovereign bond spreads of the G7 countries, using high-frequency proxies for market expectations about macroeconomic fundamentals. It allows for time-varying parameters and stochastic volatility as well as for asymmetry in the effects of countries’ fundamentals on yield spreads. The paper finds that there is substantial asymmetry in the importance of country fundamentals, which shrinks, the closer the two constituent bonds are to being substitutes. There are also considerable time variations in the role of the various determinants. In particular, there has been a reduced pricing of several risk factors in the years preceding the financial crisis, and either an over-pricing of risk or the pricing of catastrophic events like a break-up of the euro area and a re-denomination risk of euro area bonds during the European sovereign debt crisis.

• Item Type: MPRA Paper
• Language: English
• Keywords: sovereign spreads; fiscal policy; time-varying coefficients
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy

References

Aizenman, J., M. Hutchinson and Y. Jinjarak (2011). What is the Risk of European Sovereign Defaults? Fiscal Space, CDS Spreads and Market Pricing of Risk. NBER Working Paper No. 17407.

Ang, A. and F.A. Longstaff (2011). Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe. NBER Working Paper No. 16982.

Amisano, G. and O. Tristani (2012). Cross-Country Contagion in Euro Area Sovereign Spreads. Mimeo, European Central Bank.

Attinasi, M.-G., C. Checherita and C. Nickel (2010). What Explains the Surge in Euro Area Sovereign Spreads During the Financial Crisis of 2007-09? Public Finance and Management 10, 595-645.

Barrios, S., P. Iversen, M. Lewandowska and R. Setzer (2009). Determinants of Intra-Euro Area Government Bond Spreads During the Financial Crisis. European Commission Economic Papers No. 388.

Beber, A., M.W. Brandt and K.A. Kavajecz (2008). Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market. Review of Financial Studies 22(3), 925-957.

Beirne, J. and M. Fratzscher (2012). The Pricing of Sovereign Risk and Contagion During the European Sovereign Debt Crisis. Mimeo, European Central Bank.

Bernoth, K. and B. Erdogan (2012). Sovereign Bond Yield Spreads: A Time-Varying Coefficient Approach. Journal of International Money and Finance 31, 639-656.

Bernoth, K., J. von Hagen and L. Schuknecht (2012). Sovereign Risk Premiums in the European Government Bond Market. Journal of International Money and Finance 31(5), 975-995.

Borgy, V., T. Laubach, J.-S. Mésonnier and J.-P. Renne (2011). Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads. Banque de France Working Paper No. 350.

Calice, G., J. Chen and J. Williams (2011). Liquidity Spillovers in Sovereign Bond and CDS Markets: An Analysis of the Eurozone Sovereign Debt Crisis. Mimeo, University of Southampton.

Ciarlone, A., P. Piselli and G. Trebeschi (2008). Emerging market spreads in the recent financial turmoil. Bank of Italy Occasional Paper No. 35.

Claeys, P. and B. Vasicek (2012). Measuring Sovereign Bond Spillover in Europe and the Impact of Rating News. Mimeo, Czech National Bank.

Codogno, L., C. Favero and A. Missale (2003). Yield Spreads on EMU Government Bonds. Economic Policy, 503-532.

D’Agostino, A., L. Gambetti and D. Giannone (2012). Macroeconomic Forecasting and Structural Changes. Journal of Applied Econometrics, forthcoming.

De Grauwe, P. and Y. Ji (2012). Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone. Mimeo, University of Leuven.

De Santis, R. (2012). The Euro Area Sovereign Debt Crisis. Safe Haven, Credit Rating Agencies and the Spread of the Fever from Greece, Ireland and Portugal. ECB Working Paper No. 1419.

Diaz Weigel, D. and G. Gemmill (2006). What Drives Credit Risk in Emerging Markets? The Roles of Country Fundamentals and Market Co-Movements. Journal of International Money and Finance 25, 476-502.

Dovern, J., U. Fritsche and J. Slacalek (2012). Disagreement among Forecasters in G7 Countries. Forthcoming, Review of Economics and Statistics.

Draghi, M. (2012). Speech at the Global Investment Conference in London 26 July 2012, available at http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

Duffie, D., L.H. Pedersen and K. Singleton (2003). Modeling Sovereign Yield Spreads: A Case Study of Russian Debt. Journal of Finance 58, 119-159.

Dungey, M., V.L. Martin and A.R. Pagan (2000). A Multivariate Latent Factor Decomposition of International Bond Yield Spreads. Journal of Applied Econometrics 15, 697-715.

Edwards, S. (1984). LDC Foreign Borrowing and Default Risk: An Empirical Investigation, 1976- 80. American Economic Review 74, 726-734.

Edwards, S. (1986). The Pricing of Bonds and Bank Loans in International Markets, An Empirical Analysis of Developing Countries’ Foreign Borrowing. European Economic Review 30, 565- 589.

Ehrmann, M., M. Fratzscher, R. Gürkaynak and E. Swanson (2011). Convergence and Anchoring of Yield Curves in the Euro Area". Review of Economics and Statistics 93, 350–364.

Ejsing, J., W. Lemke and E. Margaritov (2012). Sovereign Bond Spreads and Fiscal Fundamentals - a Real-Time, Mixed-Frequency Approach. Mimeo, European Central Bank.

Favero, C. (2012). Modelling and Forecasting Yield Differentials in the Euro Area. A Non-linear Global VAR Model. IGIER Working Paper Series No. 431.

Favero, C., F. Giavazzi and L. Spaventa (1997). High Yields: The Spread on German Interest Rates. Economic Journal 107, 956-985.

Favero, C. and A. Missale (2012). Sovereign Spreads in the Euro Area. Which Prospects for a Eurobond? Forthcoming, Economic Policy.

Favero, C., M. Pagano and E.-L. von Thadden (2010). How Does Liquidity Affect Government Bond Yields? Journal of Financial and Quantitative Analysis 45, 107-134.

Fontana, A. and M. Scheicher (2010). An Analysis of Euro Area Sovereign CDS and their Relation with Government Bonds. European Central Bank Working Paper No. 1271.

Gelman, A., J.B. Carlin, H.S. Stern and D.B. Rubin (1995). Bayesian Data Analysis, Chapman & Hall/CRC.

Gómez-Puig, M. (2006). Size Matters for Liquidity: Evidence from EMU Sovereign Yield Spreads. Economics Letters 90, 156-162.

Hilscher, J. and Y. Nosbusch (2010). Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt. Review of Finance 14, 235-262.

Jorgenson, D. W. (2001). Information Technology and the U.S. Economy. American Economic Review 91(1), 1-32.

Kim, S., N. Shephard and S. Chib (1998). Stochastic Volatility: Likelihood Inference and Comparison with ARCH Models. Review of Economic Studies 65, 361-393.

Laubach, T. (2009). New Evidence o the Interest Rate Effects of Budget Deficits and Debt. Journal of the European Economic Association 7(4), 858-885.

Longstaff, F.A., J. Pan, L.H. Pedersen and K.J. Singleton (2011). How Sovereign is Sovereign Credit Risk? American Economic Journal: Macroeconomics 3, 75-103.

Maltritz, D. (2012). Determinants of Sovereign Yield Spreads in the Eurozone: A Bayesian Approach. Journal of International Money and Finance 31, 657-672.

Manganelli, S. and G. Wolswijk (2009). What Drives Spreads in the Euro Area Government Bond Market? Economic Policy, 191-240.

Martell, R. (2008). Understanding Common Factors in Domestic and International Bond Spreads. Review of Finance 12, 365-389.

Missio, S. and S. Watzka (2011). Financial Contagion and the European Debt Crisis. CESifo Working Paper No. 3554.

Monfort, A. and J.-P. Renne (2011). Credit and liquidity risks in euro area sovereign yield curves. Banque de France Working Paper No. 352.

Nickel, C., P. Rother and J.-C. Ruelke (2011). Fiscal Variables and Bond Spreads – Evidence from Eastern European Countries and Turkey. Applied Financial Economics 21, 1291-1307.

Paesani, P, R. Strauch and M. Kremer (2006). Public Debt and Long-Term Interest Rates. The Case of Germany, Italy and the USA. ECB Working Paper No. 656.

Primiceri, G. E. (2005). Time Varying Structural Vector Autoregression and Monetary Policy. Review of Economics Studies 72, 821-852.

Reinhart, V. and B. Sack (2001). The Changing Information Content of Market Interest Rates. BIS Quarterly Review June, 40-50.

Schuknecht, L., J. von Hagen and G. Wolswijk (2009). Government Risk Premiums in the Bond Market: EMU and Canada. European Journal of Political Economy 25, 371-384.

Uribe, M. and Yue, V. Z. (2006). Country Spreads and Emerging Countries: Who Drives Whom? Journal of International Economics 69, 6-36.

Visco I. (2012). Speech at the Annual Meeting of the Italian Banking Association in Rome 11 July 2012, available at http://www.bancaditalia.it/interventi/integov/2012/visco_abi_11072012/en-visco-110712.pdf

Zhang, X., B. Schwaab and A. Lucas (2011). Conditional Probabilities and Contagion Measures for Euro Area Sovereign Default Risk, Tinbergen Institute Discussion Paper No. TI 11-176/2/DSF29.