The determinants of euro area sovereign bond yield spreads & a valuation framework for Greek government bonds

Greece Macro Monitor (24 July 2017)

 The determinants of euro area sovereign bond yield spreads & a valuation framework for Greek government bonds

Summary of views & key findings

• In this paper we present the results of an empirical study on the determinants of the sovereign bond yield spreads in the euro area before and after the outbreak of the global financial crisis. As an additional step, we estimate a valuation model for the 10-year Greek government bond yield differentials, with the aim to measure the degree of any over- or under-valuation of Greek sovereign debt prices with respect to the macroeconomic- and market-related fundamentals.
• Although the disaggregation of sovereign credit spreads into their constituent components is a rather difficult exercise, we follow the relevant empirical literature and focus on three distinct classes of potential determinants; namely: credit risk; liquidity risk; and global risk aversion.
• Some of the main results of our study are highlighted below:
  i. Our empirical results broadly indicate that the determinants of sovereign bond yield spreads in the euro area have changed significantly across time, with the underlying fiscal-, liquidity- and global risk sentiment-related fundamentals playing a much greater role in market pricing, especially at the height of the EMU crisis and for the so-called euro-area periphery economies.
  ii. This compares with the period before the outbreak of the global crisis, which saw a significant disconnect between domestic macro/fiscal fundaments and the pricing of sovereign debt markets in the euro area.
  iii. The baseline specification of our fundamentals-based valuation model for Greek debt securities explains around 60% of the volatility in the monthly series of Greek 10yr government bond yield spreads vs. Germany from January 2009 onwards.
  iv. This implies that other factors (not accounted for in our empirical model) have been influencing the evolution of Greek sovereign debt spreads over the aforementioned period. Arguably, such factors may include: market liquidity conditions, increased political and macroeconomic uncertainty as well as periods of heightened investor fears over Greece’s euro membership.
  v. Taking these caveats and model limitations into account, our study provides an estimate of the (under-)valuation of the 10-yeak Greek bond prices relative to the underlying fundamentals over the period January 2009 to April 2017.
  vi. The degree of this undervaluation has exhibited a tendency to peak in periods of increased macroeconomic and political uncertainty in Greece and the euro area, while, most recently, the market pricing of Greek government securities has broadly aligned with the macroeconomic- and market-related fundamentals examined in our study.
  vii. If this is so, then an additional significant compression of Greek bond spreads would require a further improvement of domestic macro fundamentals and/or other, external developments, such as the provision of more clarity on the medium- and long term EU debt relief framework for Greece and the prospect of including eligible Greek debt in the ECB’s QE programme.
  viii. While the type of empirical models analyzed in the study may not be suitable for bond trading purposes, it nonetheless provides some useful insights on the way various influences (fundamentals- and non-fundamentals-related) have affected the pricing of Greek government bonds following the outbreak of the sovereign debt crisis.

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