International Bond Markets, Risk Premiums and Brexit: Theory and Empirical Findings

On June 23rd, 2016, the United Kingdom (UK) voted in a referendum to leave the European Union (EU) – an event that is now widely referred to as “Brexit”. For the vast majority of observers, this decision in favour of leave came, to a large extent, rather unexpectedly. Brexit represents a unique shock as, for the first time ever, a member state of the EU is in fact going to leave. Hence, the range of historical experience with similar events is quite limited. This restricts the extent to which previous analyses can be used in order to understand the effects of Brexit. Nevertheless, understanding its effects – and the Brexit process (the UK officially left the EU on January 31, 2020) – on individual firms, economic sectors and the economy in general is of a great importance for corporate managers, economists and policy makers. To some extent, Brexit stands for uncertainty, namely in the very early stages, but as alternative scenarios become clearer and companies, including banks in the UK and Eurozone (and economic agents in countries outside of the EU), start to adjust, various risk aspects appear on the radar of decision-makers. The picture emerging in financial markets in the UK and the Eurozone countries reveals important information. Taking financial market adjustment dynamics and the new spreads in corporate and government bond markets into account could allow firms, investors and policy makers to prepare for and mitigate the impact of Brexit, to manage the exposure of individual firms, particular sectors and the economy as a whole in a transitory environment of higher economic and political risk and to find the best possible policy mix in order to moderate its aftermath. Against this background, the present dissertation – with the subsequent three articles – analyses the effects of the Brexit vote on risk conditions in international bond markets, with the principle aim of extending existing knowledge and the literature by introducing new aspects and data as well as discussing the results; new empirical findings should help to better understand European and global financial market dynamics. In the first study using event-study techniques, we investigate the impact of Brexit-related events on the corporate bond yield spreads in the United Kingdom and Eurozone, respectively. We want to find out whether Brexit-related news, including the Brexit referendum itself, had an impact on the risk conditions in those two corporate bond markets. Our estimation results indicate that the announcement of the referendum result is associated with increasing credit spreads in the UK and EA. However, only the actual announcement of the UK referendum result itself had an influence on the credit spreads. Furthermore, we distinguish between the financial and the non-financial economic sectors in order to analyze more specific sector-related effects of the referendum event. Our estimation results suggest that UK credit spreads were more strongly influenced by the announcement of the results of the Brexit referendum than credit bond spreads in the Eurozone were. Finally, we split our sample into pre-referendum and post-referendum periods to consider the potential changing evaluation of the determinants of corporate bond spreads due to altering risk pricing triggered by the Brexit referendum result. We find that the effect of credit default risk is far stronger and plays a significant role in the post-referendum period in UK and EA, respectively. Key aspects covered in the second study refer to the cost of leaving the EU and in particular the implications for corporate bond risk premiums in the UK and the Eurozone: The gap between the interest rates of corporate bonds and government bonds could increase in the UK and Eurozone, respectively, as a result of BREXIT where the 2016 BREXIT referendum itself is considered to be a first BREXIT event (see the empirical findings), followed by the main BREXIT event, namely the day of officially leaving the EU - possibly as a No-deal BREXIT. It is as yet not clear what type of BREXIT will be implemented – hard versus soft – and it is also unclear what type of free trade agreement the EU and the UK could accomplish post-BREXIT. However, it is obviously necessary to carefully consider the background of the BREXIT dynamics and to then refer to various versions of BREXIT if one is to understand the inherent politico-economic dynamics of BREXIT – with a No-deal case representing an analytical benchmark which most politicians in the British Parliament obviously would want to avoid; a simple way to indeed avoid this case, with obvious high costs for the British economy, is not easy to discern as the UK’s political system is fractured. If the safe-haven status of the UK should be impaired by BREXIT, the rise of government bond interest rates by 0.3% would stand for the same burden as the net UK contribution to the EU. The third study analyzes recent developments in the British and European government bond markets with reference to the United Kingdom´s decision to leave the European Union. The two main goals of the study are, firstly, to examine whether the Brexit referendum result has affected the risk premium and, secondly, whether there are any changes in risk pricing following the referendum. The paper finds a significant impact of the Brexit referendum on the risk premium in selected economies. Furthermore, the results suggest that there is a considerable change in risk pricing after the announcement of the referendum result. Credit default risk and the risk aversion play a much important role in the post-referendum period than they did prior to the vote, particularly in the United Kingdom. Chapter 2 is based on a paper titled “The effects of Brexit on credit spreads: Evidence from UK and Eurozone corporate bond markets,” co-authored with Arthur Korus, and published in International Economics and Economic Policy (2019, Vol. 16(1), pp. 65-102) as a part of the special issue on “Institutional Changes and Economic Dynamics of International Capital Markets in the Context of Brexit”. Chapter 2 is only available here: https://doi.org/10.1007/s10368-018-00424-z Chapter 3 is based on a paper titled “EU28 Capital Market Perspectives of a Hard BREXIT: Theory, Empirical Findings and Policy Options” co-authored with Paul Welfens (first author), Fabian Baier, Arthur Korus and Tian Xiong, and published in The Economists’ Voice (2019, Vol. 16(1), pp. 1-16) as a part of the special issue on “The Hardships of Brexit”. Chapter 3 is only available here: https://doi.org/10.1515/ev-2019-0019 Chapter 4 is based on a paper titled “The Determinants of Sovereign Risk Premiums in the UK and the European Government Bond Market: The Impact of Brexit” published as a discussion paper at the European Institute for International Economic Relations (2020, Discussion Paper No. 271). Chapter 4 is only available here: https://eiiw.wiwi.uni-wuppertal.de/de/publikationen/eiiw-diskussionsbeitraege/nr-271.html