The determinants of government bond yield spreads in the EMU area : a panel data analysis

With the European Monetary Union (EMU), EU policymakers seemed to have achieved their goal of creating a standardized European public debt market. Indeed, euro-area governments have witnessed a considerable narrowing in their borrowing costs following the introduction of the single currency. However, the financial crisis has marked the beginning of a turnaround in the EMU government bond market, with market participants starting to discriminate between sovereign issuers. By means of Feasible Generalized Least Square (FGLS) panel estimation, this master thesis aims to identify the reasons behind this widening in EMU bond yield spreads relative to Germany. More particularly, it will study to what extent those differentials are driven by idiosyncratic factors (credit and/or liquidity risk) or global risk factors. The paper finds evidence of an alteration in market prices vis-à-vis default risk factors, with deteriorating fiscal positions being more heavily punished since the global credit crunch. Moreover, our results support that the amount and price of general investors’ risk aversion has also a significant impact on interest differentials, highlighting the save-haven status enjoyed by German bonds. Interestingly, we can also argue that investors became concerned about growth perspectives in the EMU periphery, indicating the need of growth packages stimuli. Finally, the transmission of monetary policy seems to have been impaired during the crisis episode. All in all, these dynamic properties of yield spread determinants call for models taking into account this time-varying relationship between interest differentials and sovereign risk factors.