Sovereign Yield Research Articles

Optimal Monetary and Fiscal Policies to Maximise Non-Parallel Risk Premia in Sovereign Bond Markets

In this paper, we analysed several emerging market (EM) and developed market (DM) sovereign yield curves to identify the proportion of parallel and non-parallel shifts over time. We found that non-parallel shifts are more prevalent in EM due to higher political and economic risks. Key drivers include systemic risk events like wars, debt distress, and pandemics. By backtesting a long butterfly strategy to extract non-parallel risk premia from June 2007 to March 2024, we observed that steeper slopes and greater curvature result in higher returns. We also quantified monetary and fiscal regimes to determine what types of policies are required to extract non-parallel risk premia from these sovereign yield curves. Our research suggests that countries with opposing monetary and fiscal policies possess higher return opportunities whilst countries with complementing policies require tactical butterfly strategies to optimise returns.

Euro area monetary policy effects. Does the shape of the yield curve matter?

This paper investigates the effects of monetary policy in the euro area. We make three contributions to the literature. The first is to use the information from movements in the entire yield curve around monetary policy events to shed light on the efficacy of monetary policy. The second contribution is to provide a novel and easy-to-update database of surprises based on intra-day quotes of Euro Area OIS forward rates and sovereign yields of France, Germany, Italy and Spain. Our third contribution is to show that how the term structure of interest rates changes in response to conventional and unconventional monetary policy announcements matters in shaping the response of key macroeconomic variables.

Borrowing from China and Sovereign Credit Risk

China's lending to developing nations has surged since the mid-2000s, making it these nations' largest official creditor. Contracts frequently feature unique terms, indicating China's substantial privileges as a lender. However, other lenders are also involved. We examine how these lending relationships with China affect access to credit from international bondholders. Combining data on external marketable debt and prices with Chinese lending data, we find that Chinese funding events decrease marketable debt issuance and sovereign yields. Conversely, debt restructuring with China leads to higher spreads. These findings underscore the impact of China's lending on international credit access.

Does BRRD mitigate the bank-to-sovereign risk channel?

We investigate the effectiveness of the Bank Recovery and Resolution Directive (BRRD) in mitigating the transmission of credit risk from banks to their sovereign, using CDS spreads to capture bank and sovereign credit risk for a sample of 43 banks in 8 Euro Area countries over the period 2009-2020. If the BRRD bail-in framework is credible, changes in bank default risk should not be transmitted to sovereign risk. In a novel approach we use banks earnings announcements to identify exogenous shocks to bank credit risk and investigate to what extent bank risk is transmitted to sovereign risk before and during the BRRD era. We find that bank-to-sovereign risk transmission has diminished after the introduction of the BRRD, suggesting that financial markets judge the BRRD framework as credible. The decline in bank-sovereign risk transmission is particularly significant in the periphery Euro Area countries, especially Italy and Spain, where the bank-sovereign nexus was most pronounced during the sovereign debt crisis. We report that the lower bank-to-sovereign credit risk transmission is associated with the parliamentary approval of the BRRD and not with the OMT program launched by the ECB to affect sovereign yield spreads, nor with specific bail-in or bailout cases which occurred during the BRRD era. Finally, we document that the reduction in risk transmission is most pronounced for banks classified as a Global Systemically Important Bank (G-SIB), stressing the importance of additional capital buffers imposed by Basel III.

Explaining long-term bond yields synchronization dynamics in Europe

We present a novel empirical assessment of the determinants of sovereign yield synchronization dynamics in the European Monetary Union. This topic has been seldom addressed in the existing macroeconometric literature. We use a time-varying measure of government bond yields synchronization and Bayesian Model Averaging methods to show that the persistence of synchronization measures differs significantly between GIIPS countries (Greece, Ireland, Italy, Portugal and Spain) and the rest of the monetary union, as well as across periods characterized by whether the zero lower bound of interest rates was binding or not. The degree of synchronization in inflation rates with the rest of the currency area is a robust predictor of the synchronization of sovereign yields, as opposed to economic fundamentals describing the fiscal positions of individual countries. An out-of-sample forecasting exercise reveals that accounting for the most relevant economic fundamentals can lead to improvements in the directional accuracy of the forecasts of yield synchronization rates for GIIPS countries.

Downturns and changes in the yield slope

AbstractWe show that the slope of the sovereign yield curve predicts future economic activity not only through its level but also through its changes (or differences) over time. Our results with US data show that the additional inclusion of the changes of the yield slope in the traditional regressions significantly increases the explanatory power of the yield curve. Through the yield slope decomposition, we find that positive changes in both the risk‐neutral spread and the term premium increase the likelihood of recession in the next 3 or 12 months. Estimated linear equations that directly forecast economic activity confirm the predictive power of both components in the medium run. These predictive equations also identify the term premium as the relevant component of yield slope changes for medium‐run (3–12 months) forecasts. Our out‐of‐sample exercises show that the empirical models including both the level and the differences of the slope perform better than the models including only the yield slope level.

Sovereign yield curves and the COVID-19 in emerging markets

Sovereign yield curves and the COVID-19 in emerging markets

Political ties and the yield curve

We examine the effect of political ties with the US on sovereign yields and ratings at various horizons. We find beneficial effects across both short- and long-term yields and ratings. Specifically, we find that stronger political ties with the US affect mainly the level of the yield curve of foreign sovereign bonds. These results imply that the market perceives political ties with the US as having both near- and long-term beneficial consequences.

The Liquidity Effect of the U.S. QE on Sovereign Yield Spreads of Commodity-Exporting Countries

This paper investigates the liquidity effect of the U.S. QE on the sovereign yield spreads of commodity-exporting countries by employing the two-stage least squares approach. The key contributions of the paper are in terms of our empirical findings. First, our results show that the U.S. QE has an economically and statistically significant liquidity effect in terms of both the HPW illiquidity measure and the TIPS liquidity premium. This is of policy importance because adjusting for the liquidity premium is a key stage in modeling inflationary expectations. Second, our results show that the U.S. QE reduced the liquidity premium with improved market liquidity and hence reduce sovereign yield spreads of most commodity-exporting countries. This finding is of macroeconomic importance as reduced sovereign yield spreads have been shown to lead to higher real activity and higher credit activity.

Modelling asymmetric sovereign bond yield volatility with univariate GARCH models: Evidence from India

Does Indian sovereign yield volatility reflect economic fundamentals, or whether it is a self-generated force flowing through markets with little connection to such fundamentals? To answer the question, this research explores the volatility dynamics and measures the persistence of shocks to the sovereign bond yield volatility in India from 1 January 2016, to 18 May 2022, using a family of GARCH models. The empirical results indicate the high volatility persistence across the maturity spectrum in the sample period. However, upon decomposing the markets into bull and bear phases, our results support the existence of weak volatility persistence and rapid mean reversion in the bear market. This shows that the economic response policies implemented by the government during the pandemic, including fiscal measures, have a restraining effect on sovereign yield volatility. For a positive γ, the results suggest the possibility of a “leverage effect” that is markedly different from that frequently seen in stock markets. Results further indicate that the fluctuations in Indian sovereign yields cannot be dissociated from inflation and money market volatility. Our findings herein provide valuable information and implications for policymakers and financial investors worldwide.

Geopolitical Risks and Yield Dynamics in the Australian Sovereign Bond Market

Geopolitical risks and shocks such as military conflicts, terrorist attacks, and war tensions are known to cause significant economic downturns. The main purpose of this paper is to determine the dynamics between Australian sovereign bond yields and geopolitical risk. This is achieved by employing a quantile regression analysis. The findings of this study indicate that the impact of geopolitical risk on Australian sovereign yield dynamics is asymmetrical. Furthermore, an increase in geopolitical risk only impacts short-term yields at extreme regimes. However, the impact is, by and large, insignificant. On the other hand, an increase in geopolitical risk does have a statistically significant positive impact on medium- and long-term yields across most quantiles. Lastly, an increase in geopolitical risk tends to result in a steeper yield curve at the belly of the curve but causes the yield curve to flatten at the long end. This study is the first study that holistically examines the dynamics between geopolitical risk and Australian sovereign bond yields. The study thereby contributes to the body of knowledge on Australian bond yields, specifically, and adds to the sparse body of knowledge on the dynamics between geopolitical risk and sovereign bond yields. The findings of this study have implications for monetary policy makers, given that shifts in sovereign bond yields could impact all three core mandates of the Australian Reserve Bank. Furthermore, changes in the slope of the yieldcurve could be used by monetary policy makers to pre-empt changes in future economic growth. The results of this study also relate to fiscal policy formulation, given that yields directly impact the cost of government borrowing. Lastly, portfolio managers could benefit from the results of this study, as these results provide information on the ability of Australian sovereign bonds to hedge against geopolitical risk.

Political Risk, Populism and the Economy

Abstract We study the financial and real effects of political risk shocks for Italy, Spain, Ireland, Portugal and Greece between 2008 and 2019. We build an instrument for these shocks using the changes of the sovereign yield spread around political and policy dates, and estimate their effects in the context of local projection. We show that adverse political risk shocks have negative effects on domestic financial markets and in some countries generate spillovers on the spreads of other eurozone economies. Moreover, in Italy populism-related political risk shocks have a larger effect on financial markets and they harm the real economy.

Investment attractiveness of the country based on the analysis of its sovereign yield curve

Investment attractiveness of the country based on the analysis of its sovereign yield curve

Efficacy of central bank intervention in the foreign exchange market of the BRICS countries

Central bank intervention plays a major role in managing exchange rate volatility. In comparison to advanced economies, emerging market economies are generally active in the forex market as excessive volatility of the local currency persists. The BRICS countries (Brazil, Russia, India, China and South Africa) are the major emerging economies influencing the international financial system. The paper empirically investigates the efficacy of central bank intervention in the case of the BRICS countries. It has been observed that intervention generally did not impact the exchange rate level; however, it reduced the volatility of the exchange rate. Furthermore, interventions in spot and derivatives markets are equally effective in containing exchange rate volatility, except in South Africa. It has been identified that sovereign yield spread impacts the exchange rate returns in China and South Africa and impacts the volatility in the returns in Brazil and Russia.

The long-run impact of sovereign yields on corporate yields in emerging markets

We analyze the long-run impact of sovereign yields on corporate yields of the same country, finding that, for emerging markets, the average pass-through is around one. The pass-through is larger in countries with greater sovereign risk and where sovereign bonds are more liquid. The pass-through is also greater for corporate bonds with lower ratings, shorter maturities, and those issued by financial companies and government-related firms. Our results support theoretical arguments that corporate and sovereign yields are linked together through credit risk and liquidity premiums. Consequently, high sovereign risk can slowdown growth by persistently increasing private sector borrowing costs.

Wordle for Central Bankers: Separating Impact of Words and Actions Under High Inflation– The Case of Turkey

ABSTRACT This paper investigates the effectiveness of monetary policy in Turkey, i.e. a developing country with high inflation, through its impact on the local currency denominated sovereign yield curve. Employing a two-factor, market-based methodology and introducing a new dataset, the study calculates the surprise factor for both actions (monetary policy surprise) and words (communication surprise). Checking their impacts separately, the study finds evidence that the communication provided by the Central Bank of Turkey through Monetary Policy Committee Statements help to extend the impact of the monetary policy to the long end of the yield curve, even during periods of high inflation.

The Effect of Government Reference Bonds on Corporate Borrowing Costs: Evidence from a Natural Experiment

Government bonds might provide reference entities that reduce corporate bond yields. We study China’s 2017 issuance of two U.S. dollar (USD)-denominated sovereign bonds when there were (effectively) no outstanding USD sovereigns. We find that Chinese corporate USD bonds experienced a four- to nine-basis-point decline in yield spreads, whereas corporate renminbi (RMB) bonds did not. The effect was stronger for corporate bonds with maturities similar to those of the USD sovereigns. Further consistent with the reference effect, USD-denominated corporate bonds experienced declines in bid-ask spreads and volatility; corporate bond yield spread changes became more sensitive to sovereign yield innovations; and the less-informed foreign mutual funds significantly increased their holdings of offshore USD Chinese corporate bonds. Limited evidence indicates that new corporate bond maturities shifted toward the sovereign bonds’ maturity after their issuance.This paper was accepted by Lukas Schmid, finance.Funding: B. Wang received financial support from Hong Kong Institute for Monetary Research. C. Y. Hong received financial support from the National Natural Science Foundation of China [Grant 72003125].Supplemental Material: The internet appendix and data are available at https://doi.org/10.1287/mnsc.2022.4499 .

Oil price shocks and the term structure of the US yield curve: a time-frequency analysis of spillovers and risk transmission.

This paper investigates the influence of oil demand, oil supply, and risk-driven shocks on the yield curve in the US between 1995 and 2020. The US term-structure shape is modeled by three structural factors, the level, slope, and curvature. Their empirical analysis is performed according to the Diebold-Li modified variant of the widely used Nelson-Siegel model. The technique of wavelet analysis allows investigating the interrelation of shocks in oil prices and the US yield curve along time and frequency domains, simultaneously. We report on low, medium, and high coherence zones, relative to the oil price movements and the changes in the three yield-curve factors. The low coherence intervals indicate the potential for the three latent factors to be used for creating diversification strategies capable of hedging adverse dynamics in the oil market, potentially workable through global crises. We document the variability of dynamic patterns observable for the US sovereign yield factors on per-type-of-shock basis, evidencing the potential role of the US sovereign debt investments for designing cross-asset hedge strategies for commodity and fixed-income markets.

The Use of Principal Component Analysis (PCA) in Building Yield Curve Scenarios and Identifying Relative-Value Trading Opportunities on the Romanian Government Bond Market

Based on previous research addressing the use of principal component analysis (PCA) in modeling the dynamics of sovereign yield curves, in this paper, we investigate certain characteristics of the Romanian government bond market. We perform PCA on data between March 2019 and March 2022, with emphasis on periods marked by extreme market stress, such as the outbreak of the COVID-19 pandemic in March 2020 or the Russian military invasion in Ukraine in February 2022. We find that on 25 March 2022, the first principal component explained 80.83% of the yield curve changes, the first two 91.92%, and the first three 96.87%, consistent with previous results from the literature, which state that the first three PCs generally explain around 95% of the variability in the term structure. In addition, we observe that principal components’ coefficients (factor loadings) at 2 years were lower than those at 10 years, suggesting that in case of market sell-offs, yields at 10 years increase more than those at 2 years, leading to yield curve steepenings. Interestingly, we observe that the explanatory power of the first PC increases significantly following extreme market events, when interest rates’ movements tend to become more synchronized, leading to higher correlations between tenors. We also employ PCA to check for relative-value (RV) trading signals and to assess the historical plausibility of yield curve shocks. We found that while both explanatory power and shape plausibility were characteristics of the yield curve dynamics during the outbreak of the COVID-19 pandemic, the magnitude of the market movement registered in mid-March 2020 was unlikely from a historical perspective. Finally, we use a forecasting model to derive the entire structure of the Romanian yield curve while also incorporating the trader’s view on a few benchmark yields.

Climate change and the pricing of sovereign debt: Insights from European markets

The paper analyses the impact of several climate change metrics (performance, exposure to extreme events, vulnerability, readiness, climate debt) on the cost of government borrowing expressed as both sovereign bond yields and sovereign risk premium, in a panel of European Union countries over 2000–2020. Findings show that climate-vulnerable countries, exhibiting low climate disaster managerial abilities in mitigating the climate challenges pay a higher risk premium on their sovereign debt. Euro-area countries record lower sovereign bond yields and spreads than non-members, while south-eastern European countries face higher sovereign yields and spreads. The classification of countries into different bio-geographic regions, according to observed and projected climate change patterns, shows that Atlantic-region countries experience both lower sovereign bond yields and spreads while Mediterranean countries face higher yields. Results emphasise that countries with lower fiscal space, impaired fiscal and economic indicators have to pay higher yields when issuing sovereign bonds and witness larger spreads.