The euro area sovereign debt crisis: Identifying flight-to-liquidity and the spillover mechanisms

Looking at the daily period between January 2006 and December 2012, besides the traditional credit and liquidity risks, which explain the developments of sovereign yields relative to the Bund for Greece, Ireland, Portugal, Spain and Italy, two additional factors have played a key role in the developments of euro area sovereign yield spreads: flight to liquidity benefiting the German Bund and the spillover effect from Greece. The flight to liquidity premium, which is estimated by constructing the spread between a German state guaranteed agency bond and the Bund, is behind the pricing of all euro area spreads and, specifically, is the only factor explaining the sovereign spreads for Finland and the Netherlands. The spillover effect from Greece, which is identified using complementary approaches, has contributed to developments in spreads of countries with weaker fiscal fundamentals, a lower degree of competitiveness and a higher need of foreign financing. However, a large fraction of the spillover across countries remains unexplained.     

Heterogeneity of the determinants of euro-area sovereign bond spreads; what does it tell us about financial stability?

In this paper, we assess the movements of euro area sovereign bond yield spreads vis-à-vis the German Bund as processes specified across different levels of volatility and subject to movements in asset prices and economic conditions. The determinants we use are grouped into domestic and euro-area aggregates, thus allowing us to derive results on their relative explanatory power and compare them across time and the spectrum of countries. We find that volatility influences the deterministic processes of the euro area sovereign spreads and that identical determinants have effects on spreads that vary considerably across countries. Furthermore, we find that variables reflecting investment confidence conditions and perceptions for the upcoming economic activity are significant determinants and their significance remains, to a large extent, even when controlling for fiscal variables.     

Expectations and systemic risk in EMU government bond spreads

This paper explores the determinants of 10-year sovereign bond spreads over the German Bund benchmark in the Euro Zone from 2000 to 2013, relying on cross-country quarterly data panel analysis. The paper focal point is the role of contagion and euro break-up risks in widening the sovereign bond yield differentials among EU member countries. Using a novel synthetic index capable of monitoring the sustainability of currency unions, the paper finds that market expectations of a euro’s break up and contagion from Greece were fundamental drivers of sovereign risk premia in peripheral countries.     

主权CDS对欧元区主权债务危机的影响

本文概括了主权CDS是否影响欧元区主权债务危机的几种观点和研究,发现了其中的不足之处,并试图进行弥补。文章基于面板数据,在对样本区间和国家进行分组的基础上,用向量误差修正模型(VECM)检验了主权CDS息差与国债息差的价格发现过程,此外还用向量自回归(VAR)模型分析了各国主权CDS息差之间的传染效应。结果发现,虽然主权CDS在价格发现过程中占据领先地位,但是没有证据表明主权CDS与主权债务危机之间存在必然的联系,而各国债务危机之间确实存在传染效应。     

Determinants of market-assessed sovereign risk: Economic fundamentals or market risk appetite?

This paper examines the determinants of the market-assessed sovereign risk premium, measured by the Brady bond stripped yield spread. Our study shows that, while standard economic fundamentals of a sovereign significantly affect the bond yield spread, the market's attitude towards risk is another important determinant. We construct a measure of the market's attitude towards risk called the risk appetite index (RAI), and find that for comparable changes in all the economic variables the RAI has a relatively large impact on the Brady bond yield spread. Our results explain why there is contagion in the Brady bond market and why often there is a divergence between the market's perception of the country risk premium and published ratings on sovereign creditworthiness.     

Are European sovereign bonds fairly priced? The role of modelling uncertainty

This paper examines the extent to which large swings of sovereign yields in euro area countries during the debt crisis can be attributed to fundamentals, focusing on the inherent uncertainty in bond yield models. We show that the outcomes are strongly affected by modelling choices with regard to i) the confidence bands for the model prediction, ii) the assumption whether the model coefficients are similar across countries or not, iii) the sample selection, iv) the inclusion of financial variables and v) the choice of time-varying coefficients. These choices affect the explanatory power of macro fundamentals and the extent of mispricing.     

Determinants of yield spread dynamics: Euro versus US dollar corporate bonds

This paper presents a systematic comparison between the determinants of euro and US dollar yield spread dynamics. The results show that US dollar yield spreads are significantly more affected by changes in the level and the slope of the default-free term structure and the stock market return and volatility. Surprisingly, euro yield spreads are strongly affected by the US (and not the euro) level and slope. This confirms the dominance of US interest rates in the corporate bond markets. Interestingly, I find that liquidity risk is higher for US dollar corporate bonds than euro corporate bonds. For both regions, the effect of changes in the bid-ask spread is mainly significant during periods of high liquidity risk. Finally, the results indicate that the credit cycle as measured by the region-specific default probability significantly increases US yield spreads. This is not the case for euro yield spreads.     

Macro news and bond yield spreads in the euro area

This paper analyses the effects of newspaper coverage of macro news on the spread between the yield on the 10-year German Bund and on sovereign bonds in eight countries belonging to the euro area (Belgium, France, Greece, Ireland, Italy, the Netherlands, Portugal and Spain) using daily data for the period 1999–2014. The econometric analysis is based on the estimation of a VAR-GARCH model. The results can be summarized as follows. Negative news have significant positive effects on yield spreads in all GIIPS (Greece, Ireland, Italy, Portugal and Spain) countries but Italy before September 2008; markets respond more to negative news, and their reaction has increased during the recent financial crisis. News volatility has a significant impact on yield spread volatility, the effects being more pronounced in the case of negative news and bigger in the most recent crisis period, especially in the GIIPS countries. Further, the conditional correlations between yield spreads and negative news increase in absolute value during the financial crisis (especially in the GIIPS countries), indicating a higher sensitivity of the former to the latter.     

On cross-currency transmissions between US dollar and euro LIBOR-OIS spreads

Using the causality-in-variance and causality-in-mean tests advocated by Hong (2001), we examine volatility and mean transmissions between the US dollar (USD) and euro (EUR) LIBOR-OIS spreads from January 2005 to June 2011. Interestingly, during the global financial crisis period, despite the apparently bidirectional causality-in-mean observed between the two spreads, we find evidence of significant unidirectional causality-in-variance from the EUR to the USD spread, implying information flows driven by the funding behaviors of European financial institutions. On the other hand, during the recent European sovereign debt crisis, we detect no significant causality-in-mean and causality-in-variance between the spreads.     

Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.     

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.     

Sovereign risk and belief-driven fluctuations in the euro area

Sovereign risk premia in several euro area countries have risen markedly since 2008, driving up credit spreads in the private sector as well. We propose a New Keynesian model of a two-region monetary union that accounts for this “sovereign risk channel.” The model is calibrated to the euro area as of mid-2012. We show that a combination of sovereign risk in one region and strongly procyclical fiscal policy at the aggregate level exacerbates the risk of belief-driven deflationary downturns. The model provides an argument in favor of coordinated, asymmetric fiscal stances as a way to prevent self-fulfilling debt crises.     

An Inflation‐Predicting Measure of the Output Gap in the Euro Area

Using a small Bayesian dynamic factor model of the euro area, we estimate the deviations of output from its trend that are consistent with the behavior of inflation. We label these deviations the output gap. In order to pin down the features of the model, we evaluate the accuracy of real‐time inflation forecasts from different model specifications. The version that forecasts inflation best implies that after the 2011 sovereign debt crisis, the output gap in the euro area has been much larger than the official estimates. Versions featuring a secular stagnation‐like slowdown in trend growth, and hence a small output gap after 2011, do not adequately capture the inflation developments.     

Testing for a break in the persistence in yield spreads of EMU government bonds

This study tests for a break in the persistence of EMU government bond yield spreads examining data from France, Italy and Spain and using German interest rates as a kind of benchmark. The results reported here provide evidence for breaks between 2006 and 2008. The persistence of the yield spreads against German government bonds has increased significantly after this period. This could be a sign of higher sovereign credit risk (and possibly even redenomination risk) caused by the debt crisis in the euro area. We find clear indications for non-stationary behavior after the breakpoints and empirical evidence for positive excess kurtosis and GARCH-effects when persistence increases.     

Internal or external devaluation? What does the EC Consumer Survey tell us about macroeconomic adjustment in the Euro area?

This paper explores the dynamics of national inflation expectations within the euro area during the recent crisis. Using the European Commission's Consumer Survey, we find that the strong anchoring of area-wide inflation expectations, which is typically found in the literature, does not extend to individual member states. We also measure the effect of the crisis on national inflation expectations using sovereign bond spreads and find that increases in sovereign risk have a significant negative effect on inflation expectations. This suggests that consumers expect their country to adjust through a process of internal devaluation. In contrast, we find no evidence that tensions in the sovereign bond markets increase national inflation expectations, as one would be expect under an exit or breakup scenario.     

Sovereign bond yield spreads: A time-varying coefficient approach

We study the determinants of sovereign bond yield spreads across 10 EMU countries between Q1/1999 and Q1/2010. We apply a semiparametric time-varying coefficient model to identify, to what extent an observed change in the yield spread is due to a shift in macroeconomic fundamentals or due to altering risk pricing. We find that at the beginning of EMU, the government debt level and the general investors’ risk aversion had a significant impact on interest differentials. In the subsequent years, however, financial markets paid less attention to the fiscal position of a country and the safe haven status of Germany diminished in importance. By the end of 2006, two years before the fall of Lehman Brothers, financial markets began to grant Germany safe haven status again. One year later, when financial turmoil began, the market reaction to fiscal loosening increased considerably. The altering in risk pricing over time period confirms the need of time-varying coefficient models in this context.     

Daily pricing of emerging market sovereign CDS before and during the global financial crisis

In this paper, we study the determinants of daily spreads for emerging market sovereign credit default swaps (CDSs) over the period April 2002–December 2011. Using GARCH models, we find, first, that daily CDS spreads for emerging market sovereigns are more related to global and regional risk premia than to country-specific risk factors. This result is particularly evident during the second subsample (August 2007–December 2011), where neither macroeconomic variables nor country ratings significantly explain CDS spread changes. Second, measures of US bond, equity, and CDX High Yield returns, as well as emerging market credit returns, are the most dominant drivers of CDS spread changes. Finally, our analysis suggests that CDS spreads are more strongly influenced by international spillover effects during periods of market stress than during normal times.     

The political determinants of sovereign bond yield spreads

This paper analyzes the political determinants of sovereign bond yield spreads using data for 27 emerging markets in the period 1996 to 2009. I find strong evidence that countries with parliamentary systems (as opposed to presidential regimes) and a low quality of governance face higher sovereign yield spreads, while the degree of democracy and elections play no significant role. A higher degree of political stability and the power to implement austerity measures significantly reduce sovereign yield spreads particularly in autocratic regimes, while no significant effect is detected for democratic countries. Overall, political determinants have a more pronounced impact on sovereign bond yield spreads in autocratic and closed regimes than in democratic and open countries.     

Economic policy uncertainty and risk spillovers in the Eurozone

This paper focuses on the impact of economic policy uncertainty on risk spillovers within the Eurozone and contributes to these two growing literatures. To this end, we adapt the two-step procedure developed by Adrian and Brunnermeier (forthcoming) in the framework of financial systemic risk to the sovereign bond market. Accordingly, we attempt (i) to measure the extent to which distress affecting one given country's sovereign spreads can affect the Eurozone's bond market as a whole and then (ii) to identify the determinants of risk spillovers by estimating a panel data model with macroeconomic state variables and economic policy uncertainty (EPU) indices introduced by Baker et al. (2013) as regressors. EPU indices considered concern the four largest Eurozone countries, i.e. Germany, France, Italy and Spain, as well as the United States. The model is estimated with quarterly data for ten countries representing the bulk of debt issuances within the Eurozone over a period ranging from Q4/2008 to Q2/2013, which is characterized by historically high dispersion of sovereign bond spreads either across time or across countries. Our results support the idea that economic policy uncertainty in the core economies of the Eurozone, i.e. Germany and France, as well as in the largest periphery countries, i.e. Italy and Spain, can create an environment likely to exacerbate the transmission of risk arising from abnormal developments of individual countries' sovereign spreads to the Eurozone bond market as a whole. In this respect, our results plead for larger effort of Eurozone “leaders” to reduce the uncertainty surrounding their economic policy in periods of crisis not only to avoid adverse effects on their own economies but also to reduce the risk of a destabilization of the Eurozone sovereign bond market as a whole.     

Corporate yield spreads and real interest rates

The effect of inflation on the credit spreads of corporate bonds is investigated utilising real instead of nominal interest rates in extensions of the models proposed by Longstaff and Schwartz (1995) and Collin-Dufresne et al. (2001). Inflation is a critical, non-default, component incorporated in nominal bond yields, whose effect has not been considered by existing credit spread theory. In this sense the only true test of models of credit spread pricing must utilise real rates. To illustrate these requirements the Canadian bond data of Jacoby, Liao, and Batten (2009) is utilised. This Canadian data accommodates callability and the tax effects otherwise present in U.S. bond markets. The relation with historical default rates of both U.S. and Canadian bonds is also investigated since this approach is clean of both callability and tax effects. Overall, the analysis provides additional insights into the theoretical drivers of credit spreads as well as helping to explain observed corporate bond yield behaviour in financial markets.