Sovereign bond risk premia
Sovereign bond risk premia
Thursday, 4 April 2013: 8:30 AM
Recent research on the predictability of government bond risk premia shows that the forecasting power of factors derived from the cross section of yields is dominated by macroeconomic factors that contain information not included
in the yield curve. These findings are in line with the fact that credit risk has become a more pronounced factor explaining excess bond returns. We introduce an asset pricing model in which we exploit information contained in both forward interest rates and forward CDS spreads. Our empirical analysis covers euro-zone countries with the German spot rates as risk free interest rates. We construct a market factor from the first three principal components of the German forward curve and a common and country specific credit factor from the principal components of the forward CDS curves. We find that predictability of risk premia of sovereign euro-zone bonds improves substantially if a market factor is augmented by a common plus an orthogonal country specific credit factor. The common credit factor significantly contributes to predictability of each country while the country specific factors do so only for periphery countries of the euro-zone area. The common European credit factor is positively correlated to a
European volatility index and negatively correlated to the stock index. Finally, we find that during the current crisis market and credit risk premia of government bonds are negative, a finding that we attribute to the amount of financial repression present in euro-zone countries.
in the yield curve. These findings are in line with the fact that credit risk has become a more pronounced factor explaining excess bond returns. We introduce an asset pricing model in which we exploit information contained in both forward interest rates and forward CDS spreads. Our empirical analysis covers euro-zone countries with the German spot rates as risk free interest rates. We construct a market factor from the first three principal components of the German forward curve and a common and country specific credit factor from the principal components of the forward CDS curves. We find that predictability of risk premia of sovereign euro-zone bonds improves substantially if a market factor is augmented by a common plus an orthogonal country specific credit factor. The common credit factor significantly contributes to predictability of each country while the country specific factors do so only for periphery countries of the euro-zone area. The common European credit factor is positively correlated to a
European volatility index and negatively correlated to the stock index. Finally, we find that during the current crisis market and credit risk premia of government bonds are negative, a finding that we attribute to the amount of financial repression present in euro-zone countries.