Credit and liquidity risk in sovereign bonds

Abstract

The recent financial crisis has shown huge increases in the sovereign yields of some countries. However, it is not clear a priori whether those increases come from fundamental changes in default risk or whether they are due to other determinants. We follow Ejsing et al. (2012) and Dubecq et al. (2013) to shed light on the credit and liquidity risk components of sovereign bond yields. We obtain sovereign and agency historical bond yields from France, Netherlands, Germany and Spain. Then, we consider several state-space models that exploit the differences in the yields between agency and sovereign bonds to identify the credit and liquidity factors. The estimated latent factors capture two distress periods, coinciding with the financial and the sovereign debt crises. In general, the credit effect dominates. We also identify a common European credit effect that allows us to distinguish idiosyncratic (credit) patterns.