Sovereign spreads in the euro area. Which
Prospects for a Eurobond?
Carlo A. Favero, A. Missale
QFIN Colloquia
April 2011
The Relevant Stylized Facts
 Assess the degree of integration in the European government bond
market by examining the behavior of interest rate differentials.
Examine the potential for a larger European market to better compete
with the US market, by considering the liquidity premium on German
relative to US bonds.
Look at the interest rate on bonds issued by the European Investment
Bank (EIB) to evaluate the performance of a bond issued by an EU
Institution.
Dynamics of 10-years bond yields
10-Y Bund 1990 - 2011
10
9
8
7
6
5
4
3
2
90
92
94
96
98
00
02
04
06
08
10
04
06
08
10
SPREADS ON BUNDS
10
8
6
4
2
0
-2
90
Source: Datastream
92
94
96
98
Italy
France
Netherland
Ireland
00
02
Spain
F in la n d
Be lg iu m
Portugal
Austria
Greece
Spread of 10-years government bond yields vs Bund
 After only one year from the introduction of the European
Monetary Union (EMU) in 1998 the market for fixed-income
government securities was taking the form of an almost perfectly
integrated market
 The spreads between high yield Member States (Portugal, Italy,
Spain) moved from the high peak of 300 basis points in the preEMU to less than 30 basis points of post-EURO
The differentials among different national bonds remained low,
although not negligible, for almost ten years
With the burst of the subprime financial and the euro debt crisis
the differential become sizable
Credit and Liquidity Risks and Expectations of Exchange
Rate Depreciation
 Interest rates of government bonds (same maturity and currency) may
differ because of different credit and liquidity risks and expectations of
exchange rate depreciation
 Credit risk depends on the probability that an issuer may not honour
its obligations (default risk premia). This is related to fiscal
fundamentals of each country (deficit and debt) and to GDP growth
rates, but also to external factors (global risks, “flight to quality” effects)
 Liquidity risk depends on the total amount of volumes traded in the
market, transaction costs and market efficiency
 Expectations of exchange rate depreciation were the main
components of spreads in the pre-euro era. They have disappeared in
the first decade of the second millenium and they are currently
dominated by Credit risk concerns
Spread of 10-years government bond yields vs Bund
It is possible to identify the credit risk premium form the liquidity
premium by using the Credit Default Swaps (CDS) as a proxy of the credit
risk premium
The difference between a CDS on a MS bond and the CDS on the German
Bund (the same maturity) is a measure of the credit risk premium of the
State relative to Germany
The Evidence from the data tells us that
There is a clear tendency of all spreads on Bunds in the euro-area to comove but, importantly, the nature of the comovement is not constant over
time
 The non-default component of the interest-rate spread is very small for
all Member States with only few exceptions: Finland, France and, perhaps,
the Netherlands. in a global crisis the liquidity premium rises to determine
a positive comovement between the Finnish spread and all other euro-area
spreads.
For all countries non-default components are much more likely to reflect
liquidity risk rather than expectations of depreciation of the exchange rates.
Default & non-Default components in Europe
Yields Componenents ES
Y ields Componenents GR
10
10
8
8
6
6
4
4
2
2
0
0
2005
2006
2007
2008
2009
2010
2005
2006
2007
Y ields Componenents IT
2008
2009
2010
Y ields Componenents PT
10
10
8
8
6
6
4
4
2
2
0
0
2005
2006
2007
2008
2009
2010
2005
2006
2007
Yields Componenents IR
10
8
6
4
2
0
Source: Datastream
2005
2006
2007
2008
2009
y ield spread v s GER
cds spread v s GER
non def ault component v s GER
2010
2008
2009
2010
Default & non-Default components in Europe
Yields Componenents BG
Yields Componenents FN
2.0
2.0
1.6
1.6
1.2
1.2
0.8
0.8
0.4
0.4
0.0
0.0
-0.4
-0.4
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
I
II III IV I
2010
2011
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
I
II III IV I
2010
2011
Yields Componenents FR
Yields Componenents NL
2.0
2.0
1.6
1.6
1.2
1.2
0.8
0.8
0.4
0.4
0.0
0.0
-0.4
-0.4
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
I
III IV
2005
II III IV I
2010
2011
I
II III IV
2006
I
II III IV
2007
Yields Componenents OE
2.0
1.6
1.2
0.8
0.4
0.0
-0.4
Source: Datastream
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
yield spread vs GER
cds spread vs GER
non default component vs GER
I
II III IV I
2010
2011
I
II III IV
2008
I
II III IV
2009
I
II III IV I
2010
2011
Contagion
Changing Correlations
2005-2011
The low-risk period
10
1.2
1.0
8
0.8
6
0.6
4
0.4
2
0.2
0
0.0
-2
-0.2
III IV I
2005
II III IV I
2006
II III IV I
2007
II III IV I
2008
II III IV I
2009
II III IV I
2010 2011
III
IV
I
II
2005
10-Y Spr ead on Bunds: Greece
10-Y Spread on Bunds:Italy
BAA-AAA
10-Y Spread on Bunds:Finland
III
IV
I
2006
II
2007
10-Y Spread on Bunds: Greece
10-Y Spread on Bunds:Italy
BAA-AAA
10-Y Spr ead on Bunds:Finland
The financial crisis
The Greek Debt Crisis
3.5
10
3.0
8
6
2.5
2.0
4
1.6
2
1.2
0
2.0
1.5
1.0
0.8
0.5
0.4
0.0
0.0
II
III
2007
IV
I
II
III
IV
2008
10-Y Spr ead on Bunds: Greece
10-Y Spread on Bunds: Italy
BAA-AAA
10-Y Spread on Bunds:Finland
I
II
2009
III
III
IV
2009
I
II
III
IV
2010
10- Y Spread on Bunds: Greece (rig ht axis)
10-Y Spread on Bunds:Italy (left axis)
BAA-AAA (left axis)
10-Y Spread on Bunds:Finland (left axis)
I
2011
Credit & Liquidity risk in Europe
The Financial Crisis
Periodo 2004-2010
300
1000
250
800
200
600
150
400
100
200
50
0
-200
ge
n07
m
ar
-0
7
m
ag
-0
7
lu
g07
se
t-0
7
no
v07
ge
n08
m
ar
-0
8
m
ag
-0
8
lu
g08
se
t-0
8
no
v08
ge
n09
m
ar
-0
9
m
ag
-0
9
lu
g09
ot
t-0
4
fe
b05
gi
u05
ot
t-0
5
fe
b06
gi
u06
ot
t-0
6
fe
b07
gi
u07
ot
t-0
7
fe
b08
gi
u08
ot
t-0
8
fe
b09
gi
u09
ot
t-0
9
fe
b10
gi
u10
ot
t-1
0
0
-50
IT - bund spread
GR - bund spread
FI - bund spread
IT - bund spread
GR - bund spread
FI - bund spread
IT - CDF spread
GR - CDF spread
FI - CDF spread
IT - CDF spread
GR - CDF spread
FI - CDF spread
The Greek Debt Crisis
1000
800
600
400
200
ag
o0
9
se
t-0
9
ot
t-0
no 9
v09
di
c09
ge
n10
fe
b1
m 0
ar
-1
0
ap
r10
m
ag
-1
0
gi
u10
lu
g10
ag
o10
se
t-1
0
ot
t-1
0
no
v10
di
c10
0
-200
Source: Bloomberg
IT - bund spread
GR - bund spread
FI - bund spread
IT - CDF spread
GR - CDF spread
FI - CDF spread
The Econometric Evidence
 CDS  CDS

CDS  CDS
i
t
GR
t
GER
t
GER
t

 CDS
   0  1 

CDS
i
t 1
GR
t 1
 CDS
GER
t 1
GER
t 1
 CDS
 DEBTi DEBTGER 
 GDP  GDP


i
GER





E

2 t t
 DEBTGR  DEBTGER 

 GDPGR
GDPGER 
 uti 
  3 1  t BAAt  AAAt   H t1/ 2  GR

ut 


vechH t   M  Avech ut 1ut' 1  BvechH t 1 


1
E uti u GR t   ti u GR t ,  ti  h12,t h22
,t
The Econometric Evidence
BETA_GR_BG_0710
BETA_G R_ES_0710
BETA_GR_FN_0710
1.4
1.4
1.4
1.2
1.2
1.2
1.0
1.0
1.0
0.8
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.4
0.2
0.2
0.2
0.0
0.0
0.0
-0.2
-0.2
-0.2
III
IV
I
2007
II
III
IV
I
2008
II
III
IV
I
2009
II
III
III
2010
IV
I
2007
II
III
IV
I
2008
BETA_GR_FR_0710
II
III
IV
I
2009
II
III
III
2010
1.4
1.4
1.2
1.2
1.0
1.0
1.0
0.8
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.4
0.2
0.2
0.2
0.0
0.0
0.0
-0.2
-0.2
-0.2
IV
I
II
III
IV
I
2008
II
III
IV
I
2009
II
III
III
2010
IV
I
2007
II
III
IV
I
2008
BET A_G R_NL_0710
II
III
IV
I
2009
II
III
III
2010
1.4
1.4
1.2
1.2
1.0
1.0
1.0
0.8
0.8
0.8
0.6
0.6
0.6
0.4
0.4
0.4
0.2
0.2
0.2
0.0
0.0
0.0
-0.2
IV
I
II
2008
III
IV
I
II
2009
III
IV
I
II
2010
III
IV
I
II
III
IV
I
2009
II
III
2010
I
II
III
IV
I
2008
II
III
IV
I
2009
II
III
2010
BETA_G R_PT _0710
1.2
2007
IV
BETA_GR_OE_0710
-0.2
III
2008
2007
1.4
III
II
BETA_GR_I T_0710
1.2
2007
I
BETA_GR_I R_0710
1.4
III
IV
2007
-0.2
III
IV
2007
I
II
2008
III
IV
I
II
2009
III
IV
I
II
2010
III
III
IV
2007
I
II
2008
III
IV
I
II
2009
III
IV
I
II
2010
III
Market Size
Market Size: US vs Euro Area
(bon ds wit h m a t u r it y >1 y ea r , US$ )
9000
8000
7 000
6000
5000
4000
3000
2000
1 000
Euro Area
Source: BIS
United States
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
0
Market Size
Germany vs US
4
3
2
1
0
-1
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
GER - US 10-Y asset swap spread
GER - US cds spread
US Corp Baa - Aaa spread
Source: Datastream
I
II III IV I
2010
2011
EIB Bonds
EIB
6
5
4
3
2
1
0
-1
III IV
2005
I
II III IV
2006
I
II III IV
2007
I
II III IV
2008
I
II III IV
2009
10-Y Spread on Bunds: EIB
10-Y EIB
10-Y Germany
10-Y Finland
10-Y Spread on Bunds:Finland
Source: Datastream
I
II III IV I
2010
2011
The different proposals for a eurobond
The proposals may be divide into three general schemes
 A commonly issued Eurobond with country-specific shares
backed by several guarantees (type 1)
(Proposed by or consistent with: EPDA, 2008 and De Grawve and Moesen, 2009)
.
 A commonly issued Eurobond backed by joint guarantees
(type 2)
(Proposed by or consistent with: Giovannini Group, 2000; Boonstra, 2010; Depla,
2010; and Jones, 2010)
 An EU Eurobond issued by an EU Institution (type 3)
(Proposed by or consistent with: Giovannini Group, 2000; issued by the EIB for
funding projects of the Lisbon Agenda, Majocchi, 2005; and issued by the EIB for the
purpose of financing a European Financial Stability Fund, Gros and Micossi, 2009,
Stuart Holland, 2010)
Proposals in brief
Characteristic
Type 1
Type 2
Type 3
Issuing entity
Independent Agency
Independent Agency or
EMU Fund
EU Institutions EC or
EIB
Participation
Open
Open
27 EU Member States
Yes
No, but limits on debt of
each participant
No, but limits on debt of
each EU Member States
Several
Several and Joint explicit
Several and Joint from
EU Treaty
no
yes
yes
Fixed Shares for each country
Guarantees
Mutualisation of Default Risk
Credit rating
Weighted Average of
participants
Reflect Rating of
larger participants
Highest (AAA)
if all euro-area
Members join
Liquidity
Conditional on
Market Size and
Participation
Conditional on
Market Size and
Participation
Management
Legal obstacles
Inflexible
None
Flexible
Change in TFEU
Art.125 No-Bailout
Highest (AAA)
Conditional on
Market Size
Flexible
Change in TFEU
Pros
The efficiency gains from a unified market could be substantial. Greater coordination and
market integration, especially on the supply side, may reduce liquidity premium, and thus,
the cost of borrowing for Member States. Moreover, a portfolio shift by international
investors towards safety and liquidity, i.e. a flight to quality, may affect both the credit risk
premium and the liquidity premium.
A large common market of Government bonds will most probably satisfy the global
demand for risk-free assets and better compete with US Treasuries. This is known as the
“safe haven” argument. Also, a single debt instrument would also strengthen the use of the
euro as international reserve currency.
But even more than liquidity it is credit risk which will allow Eurobond to achieve the
status of a “save haven” international benchmark. Its credit standing should be as high as
that of German Bunds. Evidence from the global financial crisis is consistent with a flight to
credit quality more than liquidity. Much depends then on the types of guarantees and /or
credit standings of participating members.
EIB bonds are priced by international investors in the same way as safe but illiquid
Finnish bonds; indeed the interest rate differential between the two bonds is practically
zero. This suggests that a Eurobond issued by an EU institution (and probably all euro-area
MS) would be perceived as the highest credit quality and could reach the “safe haven” status
if its market size approached that of US Treasuries.
Cons
Commitment to permanent issuance program will be crucial
To create a thick market, Eurobond issues would have to be sufficiently large,
regular and predictable, i.e. based on an issuing calendar specifying minimum
offered amounts. More importantly , issuance should not be discontinued. This
may prove to be difficult to the extent that the transition process will involve
high initial set-up costs and uncertain benefits in the future.
Centralized funding would raise coordination issues and would have to be
accommodated on national bond markets. This could add complexity to the
management of each MS’s total debt and run against full market integration.
A Eurobond underpinned by joint guarantees allows for a greater flexibility in
accommodating debt management. In all cases, joint issuance would require
high degree of coordination: amounts, maturity and timing of bond issues would
have to be decided by the issuing entity in close operation with MS.
Cons
The most forceful argument against a common European bond is that it
undermines fiscal discipline by removing incentives for sound budgetary
policies. At worst, it could create a moral hazard problem in that a Member State
may be tempted to free ride on other Members’ legal obligations to assume its
debt in case of default. In particular, a common Eurobond prevents financial
markets from exerting their disciplinary effects through higher interest rates and
undermines the no bailout clause that prohibits a Member State to be liable for
or assume the debt obligations of another government. Then, with lower costs of
default and deficit financing, Member States would be encouraged to run lax
fiscal policies and take up more debt. This would weaken the credibility of the
euro-zone as an area of stability and fiscal soundness.
In the end the problem of moral hazard created by the mutualisation of risks
would always emerge, as it is inherent in any insurance contract. The important
question to ask is whether a common Eurobond can reduce exposure to crisis
transmission and whether this benefit can compensate for the risk of moral
hazard.