Abstract
This paper provides new insights into the pricing of EMU sovereign debt. We employ a novel panel data approach, which allows us to jointly consider a comprehensive set of observable variables as well as additional unobservable time-varying common factors. We further add to the existing literature by using ECB’s aggregate unconventional monetary policy and the variance risk premium as explanatory variables. Our results reveal that, during the European sovereign debt crisis, monetary policy has a pronounced spread decreasing effect, whereas a rise in the variance risk premium increases yield spreads. Aggregate market liquidity has at least as much impact on yield spreads as our country-specific bond liquidity measure. Unobservable time-varying common factors explain about two-thirds of the variation in yield spread changes, whereas the major component is a systematic risk factor which captures time-varying yield spread risk premia. Our results also reveal that unobservable risk factors particularly help to explain the valuation of peripheral country bonds prior to and during the debt crisis.
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