Box 1.1. Evolution of the sovereign bond yield spreads in the euro area in the context of the financial crisis

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1 International Environment Chapter 1 Box 1.1. Evolution of the sovereign bond yield spreads in the euro area in the context of the financial crisis The financial crisis, initiated in the summer of 2 on the mortgage subprime segment in the United States, intensified significantly during the second half of 28, spreading through a growing deterioration of the economic activity, within a framework of mutual reinforcement of these movements. This situation had a reflection on the evolution of the long-term government bond yields in the main advanced economies. In the case of the euro area countries, these yields maintained a common evolution up to mid-28, decreasing between the summer of 2 and March of 28, and increasing in the following months. However, from mid-28, and more especially from the last months of the year, these yields began showing a rather different evolution among the various economies of the euro area. At the end of April 29, the 1-year government bond yields were in Greece and Ireland around 6 b.p. higher than at the end of the first half of 2. In the same period, the yields declined in the remaining euro area economies portrayed in this box, and much more significantly in Germany (change of about -14 b.p.). This behaviour induced a substantial increase in the spreads of long-term government bond yields of the euro area economies vis-à-vis Germany, reaching levels only recorded in the period previous to single currency introduction. This box intends to analyse the main developments in the spreads of government bond yields of the euro area countries vis-à-vis Germany, and identify the underlying factors to that evolution, namely in what way differences in securities liquidity and credit quality among the different States might have influenced the increase in those spreads. Determining factors of the sovereign bond yield spreads in the euro area The establishment of the euro area eliminated foreign-exchange risk among the countries integrating the monetary union and allowed for a greater integration of the national bond markets. The greater integration of these markets came from several factors, namely the almost full harmonisation both of market conventions by the issuers and tax treatment of bonds, as well as the establishment of a network of electronic trading platforms and of primary dealers present in the majority of government bond markets of the euro area. In this context, the government bond yield spreads among countries of the euro area should essentially reflect differences in sovereign credit risk and in liquidity. Regarding credit risk, part of a bond yield corresponds to the compensation demanded by investors to cover the risk of future cash-flows being different from expected due to default (credit risk premium). This premium should depend on idiosyncratic factors of each economy, which determine the amount of risk, as well as on the price of risk in the international markets. In turn, the price of risk is determined by the degree of risk aversion of investors and by the global uncertainty prevailing in international financial markets. Through credit risk the sovereign bond yield spreads should, therefore, be connected with public debt sustainability indicators in each country and with risk indicators in the international markets. 1 In times of less appetite for risk, the price of risk demanded by investors tends to increase, which on its own generates an increase in the yield spreads between countries the market considers to be of higher risk and the ones considered to have lower risk. Additionally, in situations of a country s deterioration of risk, the increase in the price of risk amplifies the impact of this deterioration on the spreads. In the case of liquidity, it would be expected that the return demanded by investors would be lower in the case of bonds that can be traded quickly, at low cost and without great price variation. The liquidity premium included in the price of each bond should contain a component associated to the expected level of liquidity for that security, as well as a compensation regarding non-anticipated changes in liquidity. This last component should depend, like the (1) In the empirical applications intending to calculate the impact of differences in the creditworthiness of sovereign issuers in the bond yield spreads, national risk factors are measured based on variables that reflect the macroeconomic situation and, in particular, the sustainability of public finances (for example, public debt and budget deficit ratios, variables that measure the economic cycle, external indebtedness ratios, sovereign debt ratings, and sovereign credit default swaps premia). On the other hand, the prevailing risk in the international financial markets is usually measured based on variables related to the uncertainty prevailing in financial markets (for example, implied volatility of the stock market), or with the risk premia in corporate bond markets (for example spreads between corporate and government bond yields, and private debt credit default swaps premia) Annual Report 28 Banco de Portugal 31

2 Chapter 1 International Environment credit risk premium, both on factors that specifically affect that security s liquidity and the global conditions of liquidity demand seen in the international markets. The liquidity differences among national securities may reflect several factors, among which differences regarding traded volumes, outstanding amounts of bonds, primary and secondary market efficiency and availability of financial instruments that allow risk hedging. 2 Regarding global conditions for liquidity, empirical evidence points to a larger demand for more liquid assets in times of greater volatility in the financial markets, i.e. when the price of risk also tends to increase. The breakdown of sovereign yield spreads into the component determined by credit quality and the component related to liquidity is not easy to perform empirically, since all these characteristic are not directly observable and are not independent. Empirical results for the euro area seem to indicate predominantly that, in the period previous to the current financial crisis, credit risk was a more important determinant factor of the sovereign yield spreads than the liquidity premium. 3 Liquidity seems, however, according to some studies, to be a relevant determining factor of spreads in periods of greater uncertainty in the financial markets and, in particular, during the current financial crisis. 4 Main evolution in spreads and on its determining factors The 1-year government bond yields spreads of the countries in the euro area vis-à-vis Germany reacted significantly for the first time to the turmoil in the financial markets in March of 28, when the markets were affected by liquidity problems in some financial institutions, notably the case of the investment bank Bear Stearns (Chart 1). Subsequently, there was some downward correction in the spreads, even though they remained at higher levels than in 2. Since May of 28 began an upward tendency, that strengthen considerably after September, when serious solvency problems in several large financial institutions in the United States and in the euro area appeared. During the fourth quarter of 28, the biggest increase in the government bond yields spreads vis-à-vis Germany happened following the announcement of the government plans to oppose the financial and economic crisis, which pointed to a deterioration in public finances. The first announced plans resulted from a coordinated response of the countries in the euro area and had as aim to support national financial systems, including a concession of govern- Chart 1 1-YEAR GOVERNMENT BOND YIELD SPREADS VIS-À-VIS GERMANY Basis points Increase in the perception of the Eastern European banking system risk Liquidity problems - Bear Stearns Sovereign rating revision (Ireland) Sovereign ratings revisions (Spain, Greece and Portugal) Fiscal stimulus plans Support measures to the financial system Lehman Brothers; AIG; Government Sponsored Enterprises Portugal Italy France Spain Belgium Ireland Netherlands Finland Austria Greece 5 1-Jun- 21-Sep May-8 22-Aug-8 12-Dec-8 3-Apr-9 Source: Thomson Reuters. (2) Empirically securities liquidity is usually evaluated based on transaction costs measures (bid/offer spreads), traded volumes or outstanding debt amounts (3) See Beber et al. (29), Bernoth et al. (24), Codogno et al. (23) and Favero et al. (2) (4) See Beber et al. (29) and ECB (29) Banco de Portugal Annual Report 28

3 International Environment Chapter 1 ment guarantees in the issuance of debt by the banks, the extension of deposit guarantees and the possibility of capital injection in financial institutions. 5,6 At the end of 28, the 1-year government bond yields spread vis-à-vis Germany more affected by this evolutions was Greece s, standing at about 23 b.p., which compares to around 2 b.p. at the end of the first half of 2. In Ireland, Italy, Portugal, Spain and Belgium the spreads recorded also very significant increases, standing at the end of the year between 83 b.p. in Belgium and 142 b.p. in Italy (at the end of the first half of 2 they varied between -1 b.p. in Ireland and 2 b.p. in Italy). In Portugal, the spread increased in the same period from 14 b.p. to 12 b.p. At the beginning of 29, specifically until mid-february, the upward trend in the sovereign bond spreads persisted. This evolution happened in the context of a new deterioration in the economic growth prospects, the downgrade of the rating of some euro area countries (Table 1), and disturbances in Eastern Europe economies, which increased the fears of spillovers to the banks and economies of Western Europe more exposed to that region. In this period, the Irish spread registered a particularly strong increase. The spreads of Greece, Portugal and Austria also recorded increases above those of the rest of the economies under analysis, reflecting in the last case a high exposure to the East European banking system. In March and April the spreads registered a decrease in a context where the international financial markets showed some correction in the extremely high levels of risk aversion seen in the previous months. At the end of April, government bond yields spreads vis-à-vis Germany were above or near 2 b.p. in Greece and Ireland, slightly above 1 b.p. in Portugal and Italy, while in the remaining countries they varied between 8 b.p. in Austria and 35 b.p. in France. Table 1 LONG-TERM SOVEREIGN CREDIT RATINGS June of 2 April of 29 S&P Moodys Fitch S&P Moodys Fitch Ireland AAA Aaa AAA AA+ (Mar-9) Aaa AA+ (Apr-9) Greece A A1 A A- (9) A1 A Italy A+ Aa2 AA- A+ Aa2 AA- Portugal AA- Aa2 AA A+ (9) Aa2 AA Spain AAA Aaa AAA AA+ (9) Aaa AAA Netherlands AAA Aaa AAA AAA Aaa AAA Austria AAA AAA AAA AAA AAA AAA Belgium AA+ Aa1 AA+ AA+ Aa1 AA+ France AAA Aaa AAA AAA Aaa AAA Finland AAA Aaa AAA AAA Aaa AAA Germany AAA Aaa AAA AAA Aaa AAA Source: Bloomberg. Note: In parenthesis are the months of the change in the ratings. i) Changes in credit risk premia The fact that sovereign bond yield spreads of the countries in the euro area vis-à-vis Germany recorded an increase during the present financial crisis is consistent with the global reduction in the risk appetite seen in the financial markets. In effect the implied volatility in the stock market and the risk premia in the corporate bond markets, indicators usually used to measure the level of investors risk appetite, registered significant increases from September of 28 and remained at levels highly superior to those observed before the crisis in the financial markets (Chart 2). (5) See Box 1.3 Government measures to support the financial sector and stabilize the financial markets, of this Report, and Box 2.1 Measures taken by the Portuguese authorities relating to the financial system during the international financial crisis, Banco de Portugal, Financial Stability Report (6) From the end of November, with the notion that the impact of the financial crisis in the real economy would be more intense and lasting than expected, several governments presented additional measures to stimulate the economy. See Box 1.5 Fiscal policy in the context of the economic and financial crisis, of this Report Annual Report 28 Banco de Portugal 33

4 Chapter 1 International Environment Chart 2 CORPORATE BOND YIELDS SPREADS AND IMPLIED STOCK MARKET VOLATILITY (VIX) (a) Per cent Basis points VIX Corporate bond yields spreads - BBB 7-1 years - US (rhs) Corporate bond yields spreads - BBB 7-1 years - euro area (rhs) 1-Jun- 21-Sep May-8 22-Aug-8 12-Dec-8 3-Apr-9 Source: Thomson Reuters. Notes: The vertical bars represent periods of the major financial market tensions as identified in Chart 1. (a) The VIX is a measure of the implied volatility of S&P 5 index options. The premium associated with the sovereign Credit Default Swaps (CDS) is a financial market measure of the credit quality of each country. 7 During 28, these indicators, evaluated relative to the CDS premium for Germany, presented an evolution similar to the one recorded by the sovereign bond yield spreads in the majority of the euro area economies. This fact suggests risk compensation might have been an important factor for the increase in these spreads (Chart 3). 8 In a context of great weakening in the economic activity, the financial system support measures and the fiscal stimulus plans generated a significant increase in investors concerns regarding the sustainability of Chart 3 5-YEAR SOVEREIGN CDS PREMIA DIFFERENCE VIS-À-VIS GERMANY Basis points Portugal Italy France Spain Belgium Ireland Netherlands Finland Austria Greece Jun- 21-Sep May-8 22-Aug-8 12-Dec-8 3-Apr-9 Source: Markit Economics. Note: The vertical bars represent periods of the major financial market tensions as identified in Chart 1. (7) A Credit Default Swap is a financial derivative that allows investors to hedging credit risk. A CDS consists in a contract between two parts on a swap of the credit risk of a third party, not involved in the contract, named reference entity. The CDS buyer (protection buyer or risk seller ) pays a periodic premium as a percentage of the related nominal credit value, expressed in basis points, and receives the insured amount if a credit event happens, that is, in case of default by the reference entity (8) However, in times of instability in the financial markets the CDS premium evolution might be affected by changes in liquidity premia Banco de Portugal Annual Report 28

5 International Environment Chapter 1 public finances and the ability of each economy to manage its debt. In particular, the significant increase in the contingent liabilities of the States, related to the support measures to the financial system, seems to have induced a transfer of credit risk perception from the banking sector to the public sector. As illustrated in Chart 4, after the announcement of government support plans to the financial sector, in October of 28, the CDS premia of the European financial institutions were substantially reduced, while the sovereign CDS premia presented a change in the opposite way. This risk transfer should have been especially important in the case of Ireland, since the Irish government guaranteed in full the liabilities of the main banking institutions, one of the banking sectors more affected by the international financial crisis of the past months. Some of the higher increases in CDS spreads happened in countries with the lowest ratings among the analysed countries, such as Greece, Italy and Portugal (Table 1). These economies have associated lower budget consolidation in the past, relatively high public debt levels and/or significant needs of external financing. Simultaneously strongly affected were countries like Ireland and Spain, where before the financial crisis there weren t significant unbalances in the public financial position, but where there has been a sharp deterioration of the economic activity, with very negative consequences for public finances (Chart 5). The increase in financing needs by the governments can be equally assessed based on data regarding public debt net issuance. The outstanding amounts of long-term debt securities issued by the central governments of the euro area have recorded a very steep growth since mid-28 (Chart 6). This increase seems to be rather moderate in the case of Germany, when compared to the majority of the remaining countries, and especially to Ireland (Chart 7). Note that the increase in debt issuance can additionally contribute to a widening in the spreads vis-à-vis Germany by an increase in securities supply versus demand. Chart 4 GERMAN SOVEREIGN DEBT AND EUROPEAN FINANCIAL INSTITUTIONS CDS PREMIA Basis points Basis points ITRAXX Europe Financial Senior 5-year ITRAXX Europe Financial Subordinated 5-year CDS premium of the German sovereign debt - 5-year (rhs) 1-Jun- 21-Sep May-8 22-Aug-8 12-Dec-8 3-Apr-9 Source: Markit Economics. Notes: The vertical bars represent periods of the major financial market tensions as identified in Chart 1. The ITRAXX Europe Financial Senior and the ITRAXX Europe Financial Subordinated are CDS indices composed by 25 European financial corporations. Annual Report 28 Banco de Portugal 35

6 Chapter 1 International Environment Chart 5 CHANGE IN THE SOVEREIGN CDS PREMIA AND PUBLIC FINANCES SITUATION Circle area=apr.9 CDS premium - Jun. CDS premium 12 Public debt (as percentage of GDP) in IE ES FI PT FR IT BE DE AT NL GR AT - Austria BE - Belgium DE - Germany ES - Spain FI - Finland FR - France GR - Greece IE - Ireland IT - Italy NL - Netherlands PT - Portugal Change in the general government balance (as percentage of GDP) between 2 and 29 Sources: European Commission and Markit Economics. Chart 6 OUTSTANDING AMOUNTS OF LONG-TERM DEBT SECURITIES ISSUED BY CENTRAL GOVERNMENTS - EURO AREA AND GERMANY Three month annualised growth rate, seasonally adjusted - euro area Annual growth rate - euro area Annual growth rate - Germany 8 Per cent Jul- 4 5 Jul- 5 6 Jul- 6 Jul- 8 Jul- 8 9 Sources: ECB and Banco de Portugal calculations. 36 Banco de Portugal Annual Report 28

7 International Environment Chapter 1 Chart 7 OUTSTANDING AMOUNTS OF LONG-TERM DEBT SECURITIES ISSUED BY EURO AREA CENTRAL GOVERNMENTS Annual growth rate Ireland Spain Austria Netherlands Portugal Italy Euro area Greece Belgium France Germany Finland Feb-9 Dec-8 Dec- Average (Dec-4;Dec-5;Dec-6) Per cent Sources: ECB and Banco de Portugal calculations. ii) Changes in liquidity premia Among the government bond markets in the euro area, the Italian, French and German markets are more liquid than the remaining, given their bigger dimension (Chart 8). Additionally, the fact that the risk hedging of the German sovereign bonds is made easier by the existence of a very efficient and liquid derivatives market on these securities (the EUREX stock market) favours the liquidity of the German market regarding the other sovereign markets in the euro area. In this context, the increase registered by the government bond yield spreads vis-à-vis Germany may reflect, besides a flight to quality, also a flight to liquidity motivated by the high uncertainty and reduced liquidity prevailing in most international financial markets over the current financial crisis. Since the beginning of the financial crisis, in mid-2, and during the first two months of 28 there seems to have been a flight to the government bond markets in general. There aren t any signs that the demand for more liquid securities may have caused a significant discrimination among bonds in the euro area. In fact, in this period the activity in some of the smaller markets of the euro area, evaluated by the daily average traded volumes in the MTS platforms, has even seen an increase (Chart 9). 9 However, in the first weeks of March of 28, traded volumes in these markets registered a strong reduction, which might have contributed for an increase in liquidity premia. 1 In the following months, the behaviour of the bid/offer spread of Portuguese 1-year bonds in MTS Portugal 11 suggests liquidity premia may have suffered a downward correction, increasing again, however, from mid-september and even more abruptly from the end of October (Chart 1). In fact, with the worsening of the financial crisis, the growing need of the financial institutions to restructure their balance sheets, the greater difficulties in obtaining financing (9) The EuroMTS and the domestic MTS markets are a network of electronic platforms where wholesale secondary market transactions of government bonds in euros are made. The comparison of traded volumes in these markets for securities of the various economies must be done with caution, since the proportion of trade done on these platforms changes depending on the country (1) The activity reduction on the MTS platform might be over-estimating the slowdown in total market activity. In effect, one of the consequences of the financial crisis has been the reduction in the proportion of transactions made through electronic platforms in favour of transactions made over-the-counter. The greater difficulty in performing transactions of big amounts on the electronic platforms without greatly affecting the prices might have contributed for this change. Additionally, in the case of Belgium and Netherlands the reduction in the traded volumes on the MTS platform might have reflected the fact that in these countries the primary dealers were allowed, starting on April the 1st, 28, to perform their market making obligationson other platforms different from the MTS (11) The bid/offer spread of a specific security is a measure of the risk premium demanded by the market-makers to own that security Annual Report 28 Banco de Portugal 37

8 Chapter 1 International Environment Chart 8 OUTSTANDING AMOUNTS OF LONG-TERM DEBT SECURITIES ISSUED BY EURO AREA CENTRAL GOVERNMENTS - END OF Ireland Finland Portugal Austria Euro billion Netherlands Greece Belgium Spain Germany France Italy Source: ECB. and the maintenance of high levels of uncertainty might have induced an increase in liquidity premia in most financial markets, including the bond market. In this context, sovereign securities of the countries in the euro area with lower liquidity may have been more affected. Additionally, the fact that risk hedging with the futures on German bonds became more incomplete, with the widening of the spreads, may also have contributed for the increase in liquidity premia in the euro area countries vis-à-vis Germany. In the first four months of 29, liquidity conditions, evaluated by these indicators, seem to have improved, probably due to a downward correction of the uncertainty prevailing in the international financial markets (Charts 9 and 1). At the end of April of 29, the bid/offer spread of the Portuguese 1-year bonds was close to the levels recorded in the first weeks of September of Banco de Portugal Annual Report 28

9 International Environment Chapter 1 Chart 9 Chart 1 AVERAGE DAILY TRADED VOLUME OF SOVEREIGN BONDS IN THE DOMESTIC MTS MARKETS BID-OFFER SPREAD OF THE 1-YEAR PORTUGUESE GOVERNMENT BONDS AND IMPLIED BOND MARKET VOLATILITY Portugal Belgium Finland Netherlands Bid-Offer spread of the 1-year Portuguese government bonds Implied volatility in the German public bond market (rhs) Euro million Ticks Per cent Dec 5 Mar 6 Jun 6 Sep 6 Dec 6 Mar Jun Sep Dec Mar 8 Jun 8 Sep 8 Dec Mar 8 9 Jan Apr Jul Oct Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 3 Source: MTS. Sources: Bloomberg and MTS Portugal. Conclusions The increase in the long-term government bond yield spreads vis-à-vis Germany seen since mid-28 seems to have reflected an increase in the relative credit risk and liquidity premia. For this evolution contributed the increase in the price of risk demanded by investors, caused by the major uncertainty and volatility prevailing in the international financial markets. In turn, the deterioration in public finances, against the backdrop of significant weakening of the economic activity, may have contributed to an upward revaluation of the credit risk in various countries, implying higher premia in countries where a greater deterioration in the public accounts is expected and in those that before the crisis already showed greater macroeconomic unbalances. The increase in the credit risk premia of several countries might have reflected also the risk transfer from the financial sector to the public sector, following the support plans of several governments, presented since the last quarter of 28. Additionally, the worsening of the turmoil in the financial markets and the subsequent greater financing difficulties have contributed to a deterioration in the liquidity conditions in the majority of markets. This situation might have affected relatively less the government bond market in Germany, when compared to the ones of the remaining euro area countries, given its greater liquidity. In general, we should highlight that the difference between liquidity and credit risk premia is complex. In particular, in times of financial crisis where the prevailing uncertainty in the markets causes both flight for quality and flight for liquidity moves, these two premia are quite connected and reinforce each other. Annual Report 28 Banco de Portugal 39

10 Chapter 1 International Environment References ECB (29), Financial Integration in Europe, April. Beber, A., Brandt M. W. and Kavajecz, K. A. (29), Flight-to quality or flight-to-liquidity? Evidence from the Euro-area bond market, Review of Financial Studies, 22-3, pp Bernoth, K., von Hagen, J., and Schknecht, L. (24), Sovereign risk premium in the European government bond market, ECB, Working Paper 369, June. Codogno, L., Favero, C. and Missale, A. (23), Yield spreads on EMU government bonds, Economic Policy, October, pp Favero, C., Pagano, M. and von Thadden, E-L (2), How does liquidity affect government bond yields?, Centre for Studies in Economics and Finance, Working Paper Banco de Portugal Annual Report 28

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