Abstract
This paper analyzes the effect of the interest rate lower bound on long-term sovereign bond spreads in the euro area. We specify a joint shadow rate term structure model for the risk-free, the German, and the Italian sovereign yield curves. In our model, the behavior of long-term spreads becomes strongly nonlinear in the underlying factors when interest rates are close to the lower bound, which occurs in the data since the beginning of 2012. We fit the model via Quasi-Maximum Likelihood and show three consequences of the nonlinear behavior of sovereign spreads: (i) they are asymmetrically distributed, (ii) they are affected by (possibly exogenous) changes in the lower bound, and (iii) they become less informative about sovereign risk than when interest rates are far from the lower bound. Shadow spreads, however, still provide reliable information.
Highlights
Long term sovereign bond spreads are closely monitored by financial markets, central banks, and governments as a reference measure of sovereign risk
In the three sections we present the model estimation results, the estimated shadow rates and shadow spreads, and the implications of the interest rate lower bound for the properties of sovereign spreads
This paper studies the effect of the interest rate lower bound on spreads between long-term sovereign yields in the euro area
Summary
Long term sovereign bond spreads are closely monitored by financial markets, central banks, and governments as a reference measure of sovereign risk. Black (1995) was the first to observe that interest rates cannot decrease below the opportunity cost of holding currency, which represents a lower bound on interest rates This implies that standard Gaussian affine dynamic term structure models are misspecified when observed yields are close to the bound, because they assign a large probability to rates below it. This situation has become relevant in several countries: in Japan since the late 1990s, in the US since 2009, and in the euro area since 2012
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