Empirical evidence on sovereign yield spread drivers in the euro area market

The financial crisis that started in mid-2007 had a significant impact on the European government’s bond market. While sovereign debt increased severely only in a few EU countries, the latter became a major problem for the area as a whole. When the spread between the yields of sovereign bonds issued by European Monetary Union (EMU) countries and the yields of bonds with similar characteristics issued by the German government (which virtually is free of default risk) increases, market perceptions of the default risk inside these countries increase as well. The paper investigates the main drivers of EMU sovereign yield spreads. The analysis is performed over the period 2002-2013 and uses Germany as the reference. We employ dynamic panel estimation techniques: panel cointegration and panel–based Vector Error Correction Models (VECM), including the Pooled Mean Group estimator (Pesaran and Smith, 1995; Pesaran, Shin and Smith, 1999). Therefore, our analysis overcomes two drawbacks characterizing the traditional dynamic panel-data literature: it does not allow only the intercept to differ across the groups, on the contrary, it permits the heterogeneity in the slope parameters. The advantage of using these approaches is that it permits taking a step forward with respect to the traditional literature on dynamic panels, by estimating a different slope parameter for each country, and by taking into account the non-stationarity of variables. Results reveal that large public debt, liquidity and political risks, are likely to put substantial upward pressures on sovereign bond yields, especially in advanced-core euro area economies. Findings are robust to different specifications and are qualitatively similar across different groups of countries