Determinants of intra-euro area
government bond spreads during the
financial crisis
by
Salvador Barrios, Per Iversen, Magdalena Lewandowska, Ralph Setzer
DG ECFIN, European Commission
- Paper does not necessarily reflect views of the European Commission -
“The sustainability of public finances in Belgium:
Regional, National and EU perspectives”
CEPS seminar, Brussels, 15 June 2011
1
EA gov bonds spreads since 1999…
Spreads of 10Y benchmark bonds to German Bund, in basis points
1600
Greece
1400
Ireland
Portugal
1200
Italy
Belgium
1000
800
600
Spain
Austria
Finland
Netherlands
France
400
200
0
Jan 99
-200
Jan 01
Jan 03
Jan 05
Jan 07
Jan 09
Jan 11
2
European Commission
…and since 2008
Spreads of 10Y benchmark bonds to German Bund, in basis points
1600
Greece
1400
1200
1000
Ireland
Portugal
Italy
Belgium
Spain
Austria
Finland
800
Netherlands
France
600
400
200
0
Jan 08
Jul 08
Jan 09
Jul 09
-200
3
Jan 10
Jul 10
Jan 11
Bond yields
before and since the crisis
CRISIS
bond yields, average, %
16
•
Countries with higher
pre-crisis spreads
also with higher
financing costs during
crisis.
•
For all countries
except GR, IE, PT
and ES, financing
costs in the crisis
period close to the
historical average.
R² = 0.62
GR
12
IE
PT
8
ES
4
DE
NL
FR
BE
FI
IT
PRE-CRISIS: Jan 1999 - Jul 2007
AT
CRISIS: Aug 2007 - May 2011
0
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
PRE-CRISIS bond yields, average, %
4
5.0
Outline
1) Theoretical determinants of spreads, literature overview
2) Government bond yields and risk aversion
3) Empirical evidence: The role of public finances and
macroeconomic imbalances
4) Summary and outlook
5
European Commission
Structure
1) Theoretical determinants of spreads, literature
overview
2) Government bond yields and risk aversion
3) Empirical evidence: The role of public finances and
macroeconomic imbalances
4) Summary and outlook
6
European Commission
Determinants of bond spreads
a) Credit risk
Differences in creditworthiness, risk that issuer fails to meet
obligations
b) Liquidity risk
Differences in the ability of a bond to be converted into cash quickly
and without any price discount
c) Risk aversion
Willingness of investors to take risk, "price of risk“
7
Literature – pre-crisis period
• Some pre-crisis studies stress the importance of international factors
(see Codogno et al. 2003, EC Policy; Longstaff et al. 2007, J of
Finance)
• Role for domestic factors, such as government debt and deficits
(Schuknecht et al. 2011, EJPE).
• Differences in government bond market liquidity have also been
found to be significant (Bernoth et al. 2006, ECB WP).
• Beber et al. (2009, Rev Fin Studies) find that, while credit risk
matters for bond valuation in normal times, liquidity becomes more
important in times of financial stress.
8
Literature – crisis period
• Global risk aversion important factor (see Haugh et al. 2009, OECD
WP)
• ECB (2009) find important role for credit risk both (measured by
CDS spreads) before and since the crisis.
• Sgherri and Zoli (2009, IMF WP) find that the sensitivity of sovereign
spreads to projected debt changes has significantly increased after
September 2008.
• Gerlach, Schulz, Wolff (2010, CEPR) find a strong role for risk
aversion and the size of banking sector
• Attinasi (2011, ECB WP): size of rescue packages without impact on
spreads
9
Bond yields and fiscal balance
16
R² = 0.73
14
GR
10Y gov bond yield
average 01/2011-06/2011
12
10
IE
PT
8
6
ES
BE
4
IT
AT
NL
FR
DE
FI
2
0
-12
-10
-8
-6
-4
Fiscal balance (in % of GDP, 2011 forecast)
Source: Commission Spring Forecast and Ecow in.
10
-2
0
Bond yields and government debt
14
GR
R² = 0.66
10Y gov bond yield
average 01/2011-06/2011
12
10
IE
PT
8
ES
6
BE
4
NL
AT
FR
60
80
FI
IT
DE
2
40
100
120
Government debt (in % of GDP, 2011 forecast)
Source: Commission spring forecast and Ecow in.
11
140
160
Bond yields and current account
14
GR
2
10Y gov bond yield
average 01/2011-06/2011, pp
R = 0.40
12
10
IE
PT
8
6
ES
IT
4
AT
BE
FR
FI
NL
DE
2
-10
-8
-6
-4
-2
0
2
4
Current account (in % of GDP, 2011 forecast )
Source: Commission Spring Forecast and Ecow in.
12
6
8
10
Bond yields and credit rating
1200
basis points
venezuela
belarus
1000
argentina
angola
bosnia
800
senegal
PT
400
bahrain
200
hungary
kazak
croatia romania
montenegro serbia
jordan
egypt
el-salvador
macedonia
morocco
tunisia
guatamla
bulgaria
costarica
panama
uruguay
colombia
peru
brazil
jamaica
ghana ukraine
gabon
pakistan
equador
seychelles
belize
rep.con.
IE
600
EL
georgia
dom_rep
nigeria
sri_lanka
iraq
vietnam
lebanon
0
BBB+
BBB
BBB-
BB+
BB
BB-
Average credit rating S&P, Fitch, Moody‘s.
13
B+
B
B-
CCC+
CCC
Structure
1) Theoretical determinants of spreads, literature overview
2) Government bond yields and risk aversion
3) Empirical evidence: The role of public finances and
macroeconomic imbalances
4) Summary and outlook
14
European Commission
Sovereign risk factor
Construction of sovereign risk factor
• Spreads to German Bund decomposed into common and countryspecific component (principal component analysis)
• First principal component (common sovereign risk factor)
– common variation in the sovereign bond spreads of individual
countries
– explains 75 percent of the total variation in the correlation matrix.
– nearly uniform weighting of the sovereign bond spreads of all
countries.
• Second principal component
– significant negative weights on GR, IE, PT
– Slightly negative weight for IT, ES
– positive weight on all other countries.
15
General risk aversion indicator
Market segments and raw stress indicators:
• Equity market: realised volatility of equity returns (Eurostoxx)
• Corporate bond market: spreads on AAA-corporate bonds and
spreads on BBB-corporate bonds
• Money market: realised volatility in 3-month EURIBOR
• Foreign exchange market: realized volatility of Yen/EUR,
USD/EUR exchange rate
16
Sovereign risk and general risk aversion
10
•
Gap between
sovereign risk and
general risk widened
during crisis, in
particular since spring
2010.
•
Sovereign risk
elevated, downward
shift in general risk.
•
Transfer of risk from
the private sector to
the public sector (see
also Ejsing and Lemke
2011).
8
6
4
2
0
-2
-4
2005
2006
2007
2008
Sovereign risk
2009
2010
General risk
17
Structure
1) Theoretical determinants of spreads, literature overview
2) Government bond yields and risk aversion
3) Empirical evidence: The role of public finances
and macroeconomic imbalances*
4) Summary and outlook
18
European Commission
Estimation approach
sov _ spread it  c  1 fiscal _ conditionsit  2 current _ account it  3 xit  u it
• Fiscal conditions
– fiscal balance for current year, as % of GDP
– debt level for current year, as % of GDP
– interest payments/total gov revenues
• Current account balance (as % of GDP)
• Liquidity risk - bid-ask spreads
• Risk aversion - general risk factor (PC analysis)
• Countries – AT, BE, ES, FI, FR, GR, IE, IT, NL, PT (with DE as
benchmark).
• Time period – January 2003-December 2009, quarterly data
• Methodology – panel regressions, OLS-PCSE (Beck and Katz 1999)
19
Results panel regression
(1)
0.062***
(0.018)
(2)
0.071***
(0.019)
(3)
0.071***
(0.011)
(4)
0.050***
(0.017)
Bid-ask
0.012***
(0.002)
0.011***
(0.003)
0.003*
(0.002)
0.016***
(0.002)
Fiscal balance
-0.024***
(0.006)
-0.013**
(0.005)
-0.015***
(0.003)
-0.008***
(0.003)
-0.005***
(0.001)
Risk aversion
Current account
(5)
0.151***
(0.013)
-0.008***
(0.002)
-0.012***
(0.003)
Debt
0.003***
(0.000)
0.002***
(0.000)
Debt2
0.007**
(0.003)
0.005*
(0.003)
-0.001
(0.000)
0.001***
(0.000)
Interest payment
Constant
0.007***
(0.002)
0.001***
(0.000)
0.000
(0.000)
0.001***
(0.000)
Observations
280
280
280
280
280
2
R
0.66
0.68
0.68
0.72
0.65
Notes: Standard errors in parentheses
* significant at 10%; ** significant at 5%; *** significant at 1%
Coefficients estimated using panel-corrected standard errors assuming first-order autocorrelation in
disturbance terms based on the Durbin Watson approach
20
Interaction effects I
Impact of budget balance on 10Y gov bond spreads
at high level of risk aversion and high debt level
21
Interaction effects II
Impact of budgetary balance on 10Y gov bond spread
at high level of risk aversion and large current account deficit
22
Structure
1) Theoretical determinants of spreads, literature overview
2) Government bond yields and risk aversion
3) Empirical evidence: The role of public finances and
macroeconomic imbalances
4) Summary and outlook
23
European Commission
Summary
• International factors such as general risk perception play a
crucial role in explaining EA sovereign bond yield differentials.
• Role played by domestic factors is smaller, but non-negligible.
A deteriorating domestic outlook for fiscal deficits is associated with
higher bond yields.
• Significant interaction of general risk aversion and
macroeconomic fundamentals. Domestic factors have become
more important in times of financial stress, when international
investors started to discriminate more between countries.
• Combination of high risk aversion and large current account
deficits tend to magnify the incidence of deteriorated public
finances on government bond yield spreads.
24
Looking ahead…
• Regaining bond market access crucial for programme
countries (GR, IE, PT)
• Unlikely that spreads will revert to pre-crisis levels in the near
future:
– Debt levels have increased significantly in a number of countries
(relative to German benchmark).
– Contingent liabilities assumed by the public sector in rescuing
the financial sector will continue to weigh on the outlook for
public finances.
– Spread widening also correction of (too) narrow spreads in precrisis period.
• Will greater market discrimination across countries provide
higher incentives for governments to attain and maintain
sustainable public finances?
25
Thank you for your attention
26