Sovereign bond spread drivers in the EU market after the global financial crisis

Recently the world economy was confronted to the worst financial crisis since the great depression. This unprecedented crisis started in mid-2007 had a huge impact on the European government bond market. The mix of deteriorating economic prospects, failing commodity prices, growing risk aversion and severe financial stress has raised concerns about the risk of sharp increases in debt associated to huge fiscal deficits and the use of public funds to support the financial and corporate sectors. Market interest rates on sovereign debt started to spike upward across several EU countries since 2010 affecting economies with large and vulnerable banking sectors.

With respect to the recent crisis, while the increase in sovereign debt has been most pronounced only in a few Euro zone countries, it became a major problem for the area as a whole. The spreads between the yields on sovereign bonds issued by Germany (with virtually no default risk) and the yields on similar bonds issued by other EU countries go up when market perceptions of the default risk of the latter rises. Hence, yield spreads measure the premiums required by investors on these securities and are one of the costs that countries must pay for borrowing on external markets.

Given the economic importance of yield spreads, a large body of the financial literature focuses on their determinants. Most of these studies discuss almost exclusively emerging markets because previous crises had the greatest impacts on these economies. The novelty of the current crisis is that it strikes severely advanced countries as well. The purpose of this paper is to identify empirically the key drivers of sovereign bond spreads in all EU-27 countries from an ex-post perspective. A particular focus will be devoted to Euro area Members and both long- and short-run determinants of their spreads relative to Germany. Including in the analysis EU members that did not introduce the common European currency will permit to evaluate the role of the exchange rate policy as a determinant of bond spreads. This type of analysis will also reveal ways for national and regional (supra-national) governments to better asses sovereign default risks and, thus, to avoid financial stress.

Technically, we address three main questions. First, we ask what proportion of the change in market spreads is explained by changes in the underlying fundamentals, controlling for external factors, liquidity and market risks. Second, we employ a measure of sovereign risk as Edwards (1984) who defines the log of spreads as a linear function of several explanatory variables. Third, we distinguish between EU member states within and outside the Euro area and question whether long-run and short-run determinants of spreads to Germany affect EU members uniformly. To answer these questions, we explore data on EU-27 over the 2003-2011 period. We employ panel data techniques in a regression model where spreads to Germany are explained by set of traditional variables as well as a number of policy variables.