Systemic and Idiosyncratic Risk in EU-15 Sovereign Yield Spreads after Seven Years of Monetary Union

The market capitalisation of international bond markets is much larger than that of international equity markets. However, compared to the large body of literature on international equity market linkages, there are far fewer empirical studies of bond systemic risk or international bond market co-movements. The extent of international bond market linkages merits investigation, as it may have important implications for the cost of financing fiscal deficit, monetary policymaking independence, modelling and forecasting long-term interest rates, and bond portfolio diversification. In this paper, we investigate the relative influence of systemic and idiosyncratic risk factors on yield spreads over 10-year German government securities during the seven years after the beginning of Monetary Integration. We estimate both panel regressions for the two groups of EU-15 countries (EMU and non-EMU) and specific-country regressions for the nine countries in the EMU group and the three countries in the non-EMU group. All estimations include both domestic (differences in market liquidity and credit risk) and international risk factors. The results present clear evidence that it was mostly idiosyncratic rather than systemic risk factors that drove the evolution of 10-year yield spread differentials over Germany in all EMU countries during the seven years after the beginning of Monetary Integration. Conversely, in the case of non-EMU countries, adjusted yield spreads (corrected from the foreign exchange factor) are influenced more by systemic risk factors. The fact that these countries do not share a common Monetary Policy might explain these results, which may show that government bonds from EMU countries have a better safe-haven status that those of non-EMU countries.     

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.     

Assessing Bond Market Developments Pot-Euro

As a result of global trends in the financial industry, European financial markets are in the midst of a major transformation, and Economic and Monetary Union (EMU) is acting as a primary catalyst for such change. Over time financial integration will provide European markets with sufficient liquidity and scale to turn them into effective rivals of the U.S. markets.
This paper provides a framework for assessing the likely consequences of EMU for the evolution of European bond markets. First, it discusses broad fundamental shifts in international capital flows and how EMU is expected to affect them. Second, it analyzes in some detail the two most important portfolio shifts expected to accompany Monetary Union: potential changes in currency reserves held by central banks and diversification of international investors' portfolios. Third, it considers the possibility that the asset management industry and households' increased appetite for risk will lead to a major shift on the demand side. On the supply side, it explores the likely effect of Monetary Union on government bond yield spreads and expected changes in the key pricing factors.
The paper concludes with an overview of the considerable growth prospects for the European corporate bond market. In the Euromarket, which has traditionally been the preserve of borrowers of high credit standing, there have already been signs of increased interest in corporate issues, particularly lower-rated ones. The search for higher yields by investors, greater expertise in analyzing credit risks by institutional investors, and reduced issuance in European government bond markets will combine to spur growth in the European corporate bond market. As a consequence, the traditional bank-oriented relations will clearly weaken, and more companies will find opportunities to raise capital and obtain financing at lower cost.     

Trading strategies based on term structure model residuals

The term structure of interest rates is an important input for basically every pricing model and is mostly calibrated on coupon bond prices. Therefore, the estimated interest rates should accurately explain the market prices of these bonds. However, nearly all empirical papers on interest rate estimation, e.g. Svensson, L.E.O. 1994. Estimating and interpreting forward interest rates: Sweden 1992–1994, IMF Working Paper, International Monetary Fund, report significant pricing errors in their sample. So an important question is what drives these pricing errors of the bonds. One simple explanation would be different tax treatment or different liquidity, but most papers on this research topic, e.g. Elton, E., and T.C. Green. 1998. Tax and liquidity effects in pricing government bonds. Journal of Finance 53: 1533–62, cannot fully explain the observed pricing errors. Therefore, these errors must be at least partially caused by either model misspecification or by the deviation of particular bond prices from general market conditions, i.e. mispricing revealing insufficient market efficiency. We provide empirical evidence for the German government bond market that risk-adjusted trading strategies based on bond pricing errors can yield about 15 basis points p.a. abnormal return compared to benchmark portfolios. Furthermore, the abnormal returns are continuously achieved over the whole time period and not randomly on a few days and show a relation to changes in the level and the curvature of the term structure of interest rates. Therefore, pricing errors contain economic information about deviations of bond prices from general market conditions and are not exclusively caused by model misspecification and/or differences in liquidity and tax treatment of individual bonds.     

Sovereign credit ratings and financial markets linkages: Application to European data

We use EU sovereign bond yield and CDS spreads daily data to carry out an event study analysis on the reaction of government yield spreads before and after announcements from rating agencies (Standard & Poor’s, Moody’s, Fitch). Our results show significant responses of government bond yield spreads to changes in rating notations and outlook, particularly in the case of negative announcements. Announcements are not anticipated at 1–2 months horizon but there is bi-directional causality between ratings and spreads within 1–2 weeks; spillover effects especially among EMU countries and from lower rated countries to higher rated countries; and persistence effects for recently downgraded countries.     

Idiosyncratic volatility vs. liquidity? Evidence from the US corporate bond market

Our objective in this paper is to determine empirically the extent to which fixed-income investors are concerned about the relative effects of equity volatility and bond liquidity in the cross-section of corporate bond spreads. Our tests reveal that while both volatility and liquidity effects are significant, volatility, representing ex-ante credit shock, has the first-order impact, and liquidity represented by bond characteristics and price impact measure has the secondary impact on bond spreads. Conditional analysis further reveals that distressed bonds and distress regimes are both associated with significantly higher impact of volatility and liquidity shocks. However, the relative impact of these effects varies conditional on the underlying bond attributes and overall market conditions.     

A time-varying common risk factor affecting corporate yield spreads

A time-varying common risk factor affecting corporate yield spreads is modelled by extending a panel data model. The panel data model accommodates a common factor, which is associated with time-varying individual effects. The factor multiplied by a bond-specific unobservable is identified as a systematic risk premium. In disentangling the systematic risk premium, both credit and liquidity risks are evaluated; the credit risk is assessed by bond rating, and the liquidity risk is indirectly measured by discrepancy in quoted yields by brokerage firms. Parameters are estimated by the generalized method of moments procedure. The model is tested on the corporate bond market in Japan. Empirical results show that the time-varying common risk factor is successfully estimated together with credit and liquidity risks.     

Internal liquidity risk in corporate bond yield spreads

The recent global financial crisis reveals the important role of internal liquidity risk in corporate credit risk. However, few existing studies investigate its effects on bond yield spreads. Panel data for the period from year 1993 through 2008 show that corporate internal liquidity risk significantly impacts bond yield spreads (and changes) when controlling for well-known bond yield determinant variables, traditional accounting measures of corporate debt servicing ability, cash flow volatility, credit ratings, and state variables. This finding indicates that internal liquidity risk should therefore be incorporated into bond yield spread modeling.     

Factor pricing in commodity futures and the role of liquidity

This paper empirically investigates the pricing factors and their associated risk premiums of commodity futures. Existing pricing factors in equity and bond markets, including market premium and term structure, are tested in commodity futures markets. Hedging pressure in commodity futures markets and momentum effects is also considered. This study combines these factors to discuss their importance in explaining commodity future returns, while the literature has studied these factors separately. One of the important pricing factors in equity and bond markets is liquidity, but its role as a pricing factor in commodity futures markets has not yet been studied. To our knowledge, this research is the first to study liquidity as a pricing factor in commodity futures. The risk premiums of two momentum factors and speculators’ hedging pressure range from 2% to 3% per month and are greater than the risk premiums of roll yield (0.8%) and liquidity (0.5%). The result of a significant liquidity premium suggests that liquidity is priced in commodity futures.     

The integration of bank syndicated loan and junk bond markets

This paper hypothesizes that the special role of banks as corporate quasi-insiders has been changing due to developments in informational, legal and institutional infrastructures of syndicated loan markets. We investigate the integration of intermediated and disintermediated financial markets through highly leveraged transaction (HLT) syndicated loans during the 1990s. We demonstrate that, with the emergence of traded HLT syndicated loans as an alternative high-yield asset to high-yield bonds, market integration has dramatically increased. Taking the late 1980s and 1990s together, different factors explain the movement of credit spreads of the two markets. HLT loan market’s spreads are strongly affected by bank liquidity. Bank liquidity’s effect on HLT loan spreads disappears after 1993. From 1994–1999, junk bond market liquidity factors affect bank loan pricing. We interpret these changes as evidence of the erosion of bank specialness.     

Discrete-time option pricing with stochastic liquidity

Classical option pricing theories are usually built on the law of one price, neglecting the impact of market liquidity that may contribute to significant bid-ask spreads. Within the framework of conic finance, we develop a stochastic liquidity model, extending the discrete-time constant liquidity model of Madan (2010). With this extension, we can replicate the term and skew structures of bid-ask spreads typically observed in option markets. We show how to implement such a stochastic liquidity model within our framework using multidimensional binomial trees and we calibrate it to call and put options on the S&P 500.     

Spanish Treasury bond market liquidity and volatility pre- and post-European Monetary Union

Spain enacted a number of important debt management initiatives in 1997 to prepare its Treasury bond market for European Monetary Union. We interpret the impacts of these changes through shifts in a bond liquidity “life cycle” function. Furthermore, we highlight the importance of expected average future liquidity in explaining Spanish bond liquidity premiums. We also uncover pricing biases that support the Spanish Treasury’s tactical decision to target high-coupon, premium bonds in its pre-EMU debt exchanges. Finally, we show that EMU has been associated with both a decrease in bond yield volatility and an increase in pricing efficiency.     

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.     

Dynamic effects of idiosyncratic volatility and liquidity on corporate bond spreads

We study the dynamic impact of idiosyncratic volatility and bond liquidity on corporate bond spreads over time and empirically disentangle both effects. Using an extensive data set, we find that both idiosyncratic volatility and liquidity are critical mainly for the distress portfolios, i.e., low-rated and short-term bonds; for others only volatility matters. The effects of volatility and liquidity shocks on bond spreads were both exacerbated during the recent financial crisis. Liquidity shocks are quickly absorbed into bonds prices; however, volatility shocks are more persistent and have a long-term effect. Our results overall suggest significant differences between how volatility and liquidity dynamically impact bond spreads.     

Liquidity of emerging markets

Emerging markets are characterized by volatile, but substantial returns that can easily exceed 75% per annum. Balancing these lofty returns are liquidity costs that, using the bid–ask spread as a basis, range from 1% for the Taiwanese market to over 47% for the Russian market. However, the paucity of bid–ask spread information across countries and time requires the use of liquidity estimates in emerging markets even though little is known about the efficacy of these estimates in measuring bid–ask spread costs. Using firm-level quoted bid–ask spreads as a basis, I find that price-based liquidity measures of Lesmond et al. [Review of Financial Studies 12 (1999) 1113] and Roll [Journal of Finance 39 (1984) 1127] perform better at representing cross-country liquidity effects than do volume based liquidity measures. Within-country liquidity is best measured with the liquidity estimates of either Lesmond, Ogden, and Trzcinka or, to a lesser extent, Amihud (2002). Examining the impact of legal origin and political institutions on liquidity levels shows that countries with weak political and legal institutions have significantly higher liquidity costs than do countries with strong political and legal systems, even to the exclusion of legal origin or insider trading enforcement. Higher incremental political risk is associated with a 10 basis point increase in transaction costs, using the Lesmond, Ogden, and Trzcinka estimate, or a 1.9% increase in price impact costs, using the Amihud estimate.     

Integration of European bond markets

I investigate the time variation in the integration of EU government bond markets. The integration is measured by the explanatory power of European factor portfolios for the individual bond markets for each year. The integration of the government bond markets is stronger for EMU than non-EMU members and stronger for old than new EU members. For EMU countries, the integration is weaker the lower the credit rating is. During the recent crisis periods, the integration is weaker, particularly for EMU countries.     

The impact of the euro on Europe's financial markets

This paper presents an overview of the impact of the introduction of the euro on Europe's financial structure over the first four years since the start of EMU. It analyzes changes in money markets, bond markets, equity markets and foreign exchange markets. Euro's role in originating or catalyzing trends has been uneven across the spectrum of financial markets. From the supply side, banks and investors in fixed income markets have become more focused on the characteristics of individual borrowers rather than the nationality of the issuer and have built up expertise to evaluate credit risk. European equity markets have also been affected by the enhanced ability of investors to build strategies with a pan‐European perspective as prices increasingly reflected risk factors specific to industrial sectors rather than individual countries. On the borrower side, EMU has increased the attractiveness of market‐based financing methods by allowing debt issuers to tap institutional portfolios across the euro area. Lower barriers to cross‐border financial transactions have also increased the contestability of the market for financial services, be it at the wholesale or the retail level. The introduction of the euro has also highlighted the shortcomings of existing institutional structures and areas where excessive focus on narrowly defined interests may stand in the way of realizing the full potential benefits from the new environment. Diverging legal and institutional infrastructures and market practices can impede further financial market development and deepening. Hence, the euro has put a premium on cooperation between national authorities and institution as a means of achieving a more harmonized financial environment. The impact of EMU on depth in foreign exchange markets has been less clear‐cut, as volatility, spreads, trading volumes and liquidity appear not to have changed in a substantial way. Overall, it seems that the new currency has made some progress towards the goal of becoming a currency of international stature that would rival that of the US dollar. However, a number of the necessary next steps towards achieving this goal are also among the trickiest to implement.     

Securitization markets and central banking: An evaluation of the term asset-backed securities loan facility

In response to the near collapse of US securitization markets in 2008, the Federal Reserve created the Term Asset-Backed Securities Loan Facility, which offered non-recourse loans to finance investors’ purchases of certain highly rated asset-backed securities. We study the effects of this program and find that it lowered interest rate spreads for some categories of asset-backed securities but had little impact on the pricing of individual securities. These findings suggest that the program improved conditions in securitization markets but did not subsidize individual securities. We also find that the risk of loss to the US government was small.     

Latent liquidity: A new measure of liquidity,with an application to corporate bonds

We present a new measure of liquidity known as “latent liquidity” and apply it to a unique corporate bond database. Latent liquidity is defined as the weighted average turnover of investors who hold a bond, in which the weights are the fractional investor holdings. It can be used to measure liquidity in markets with sparse transactions data. For bonds that trade frequently, our measure has predictive power for both transaction costs and the price impact of trading, over and above trading activity and bond-specific characteristics thought to be related to liquidity. Additionally, this measure exhibits relationships with bond characteristics similar to those of other trade-based measures.     

Liquidity and credit premia in the yields of highly-rated sovereign bonds

This paper quantifies liquidity and credit premia in German and French government bond yields. For this purpose, we estimate term structures of government-guaranteed agency bonds and exploit the fact that differences in their yields vis-à-vis government bonds are mainly driven by liquidity effects. Adding information on benchmark rates, we estimate liquidity and credit premia as latent factors in a state-space framework. The results allow us, first, to quantify the price impact of safe-haven flows on sovereign yields, which strongly affected very liquid bond markets during the recent financial crisis. Second, we quantify credit premia for highly rated governments, offering an important alternative to the information based on CDS markets.