Determinants of government bond spreads in the euro area: in good times as in bad

Abstract

Government bond spreads increased rapidly during the financial turmoil in the euro area. In general, government bond spreads in the euro area are attributed to solvency and liquidity risks and determinants thereof. This paper proposes the use of latent processes to model the time variation present in the evaluation of these determinants. In contrast to approaches using global measures like the US corporate bond spreads or short-term interest rates to approximate time variation, our model is also flexible enough to deal with the unfolding of the financial crisis. The findings suggest that the expected debt-to-GDP ratio explains a major part of the differences in bond yields in the euro area between 2003 and the unfolding of the financial crises. Coefficients for many determinants increased rapidly during the financial crises. Especially market capitalization gained relative importance in winter 2008/2009.