Working Paper Series no. 350: Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads

Abstract

This paper analyses the role of fiscal factors in the joint dynamics of eight euro-area government-bond yield curves within an arbitrage-free affine term structure model of potentially defaultable sovereign bonds. Thanks to a new, computationally-efficient algorithm, we are able to estimate both the historical and risk-neutral dynamics of the pricing factors in a single step by likelihood maximization. We find confirmation that the perceived deterioration in public finances was the major driver of the widening in bond spreads towards Germany after 2008, albeit through both heightened required compensations for default risk and increases in associated risk premia.

Vladimir Borgy, Thomas Laubach, Jean-Stéphane Mésonnier and Jean-Paul Renne
October 2011

Classification JEL : C32, E6, G12, H6

Keywords : Government debt, affine term structure models, default risk, yield spreads, fiscal projections.