Theory of Diversification and Cross-subsidy for Eurobonds

In the face of excessive yield spreads on sovereign bonds in the European Monetary Union, the issuance of joint debt commonly known as Eurobonds has been proposed to ease the access to credit for fiscally struggling countries. This paper is the first to consider Eurobonds in terms of diversification and cross-subsidy benefits. It shows that the risk-sharing nature of Eurobonds lowers sovereign default probability in a non-replicable way for investors thereby lowering investment losses on a macro-level. Countries benefit as well from lower default probability that prevents sovereign bankruptcy costs. On a micro-level, fiscally strong countries have to weigh the benefits of Eurobonds against the two-fold costs of higher interest payments and financial support for defaulting countries. With further research, the argument brought forward in this paper will contribute to a more comprehensive debate about the benefits and costs of Eurobonds