This paper analyses the performance of the European bond market with a particular focus on analysing yields and yield spreads in the Euro Zone area. The study observes poor performance of the bond market over the 18-month period April 2010 to September 2011. Countries with high credit and liquidity risks such as Greece, the Republic of Ireland, Spain, Italy and Portugal exhibit significant high yields and yield spreads over the period under analysis.
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Significant developments have occurred in the European Bond Market over since the onset of the global financial crisis in 2007. In the light of these developments, this paper evaluates the performance of the European bond market by analysing yield spreads of the Euro Zone over the 18-month period 2010 to September 2011. The rest of the paper is organised as follows: section 2 provides a literature review, which focuses on understanding bonds, the factors that determine their prices and empirical evidence; section 3 provides a methodology for evaluating the performance of the European bond market; section 4 presents empirical results and analysis; and section 5 presents conclusions and recommendations.
One of the main variables used in measuring the performance of a bond is the yield spread. The yield serves as a measure of risk associated with investing in the bonds. Consequently, the higher the risk of a bond, the higher will be its yield and thus, the higher will be the yield spread relative to a particular benchmark bond.
Yield spreads on national bond markets depend on a number of factors. These include credit risk, liquidity risk and risk aversion (Barrios et al., 2009). With regards to credit risk, bond yield spreads are affected by three types of credit risk including default risk, credit spread risk, and downgrade risk. In general, the yield spread increases with the credit risk and vice versa.
Empirical evidence suggests that yield spreads depend on both national and international factors. Codgogno et al. (2003); and Longstaff et al. (2007) argue in favour of international factors. With respect to national factors, credit risk has been found to be an important factor in determining yield spreads (e.g., Schuknecht et al., 2008; ECB, 2009). Despite the importance of credit risk, Beber et al. (2006) argue that liquidity risk is more relevant downturns and that the impact of credit risk is only relevant during stable economic conditions. Haugh et al. (2009) argue in favour of the general degree of risk aversion. In addition, government and Central Bank intervention in the economy also have an impact on bond yield spreads. For example, a European Central Bank Study ECB (2008) study suggests that stimulus packages aimed at rescuing banks from collapsing during the global financial crisis resulted to the immediate transfer of risk from the private to the public sector thus leading to an increase in government bond yield spreads.
To understand how the European Bond market has performed over the last 18 months, this paper looks at how the yield 10 year government bond yield spread of the Euro Area has moved over the period April 2010 to September 2011. The Euro area consists of 15 countries. These countries are presented in Appendix 1.
The yield spread is computed by taking the yield on the 10-Year government bond and subtracting the benchmark yield. In this case, the benchmark yield is the German 10-Year government bond. Germany has the lowest level of inflation and thus the most stable economy in the Euro Zone (Fabozzi, 2011). This explains why its 10-Year government bond yield is used as the benchmark. Data on yields is obtained from the website of the European Central Bank and observations are based on a monthly frequency.
Analysis and Discussion
Appendix 1 illustrates the 10-year government bond yield for euro zone member countries over the period April 2010 to September 2011. It can be observed that Greece had the highest 10-Year government bond yield of 12.35% whileGermanyhad the lowest average yield of 2.72% on its 10-Year government bond. Other countries with significantly high yields on their 10-Year government bonds include the Republic of Ireland with an average yield of 8.05% and Portugal with an average yield 7.66%. Cyprus, Italy, Spain, Slovenia and Slovakia also have significantly high yields with yields on their 10-Year government bonds ranging from 4.08% to 5.01%. It can also be observed that the yields have been rising for all countries in the Euro Zone as illustrated in Appendix 3. Appendix 2 illustrates the 10-Year government bond yield spreads for each of the euro zone relative to the German 10-Year Government bond. Appendix 4 illustrates the corresponding movement in the yield spreads. Like the yields, the yield spreads for Greece, the Republic of Ireland, Italy, Spain, Portugal Slovakia and Slovania have been significantly higher than the rest of the other countries. Moreover, the yield spreads have increased significantly over the period under investigation.
The countries with alarming yields and yield spreads have made news headlines of various financial publications over the last 18 months.Greecefor example, has been unable to meet its sovereign debt obligations and has been forced to seek help from the ECB. Portugal, the Republic of Ireland, Italy and Spain have also been struggling with meeting their sovereign debt commitments (The Economist, 2011; New York Times, 2011).
In general, the rising yields and yield spreads in Greece, Portugal, Spain, Italy and the Republic of Ireland can be attributed to an increase in credit risk, risk aversion and liquidity risk.
The rise in the government bond yield spreads have also been attributed to auctions that were to take place in Portugal and Spain (Reuters, 2011).
Conclusions and Recommendations
Based on the analysis above, a number of conclusions can be drawn. Firstly, the yields for almost all the countries under analysis have been rising. Significant increases in yields can be observed for countries with high credit and liquidity risks. These risks have led to an increase in investor’s degree of risk aversion and thus to an increase in the risk premium required for investing in their bonds. Yield spreads have also been increasing for all countries and significantly high for countries with high credit and liquidity risk, as well as a high degree of risk aversion. Governments in Europe and the European Central Bank are committed to supporting troubled countries from defaulting on their debt so as to avoid a Euro Zone debt crisis. Assuming that these efforts are going to be fruitful, there will be reductions in the cost of borrowing. Consequently one should expect to observe a decline in yields and yield spreads over the next 12 months (The Economist, 2011). However, given that Germany remains the most stable economy amongst Euro Zone economies, it is unlikely that the yield spreads over the German government bonds will every narrow to pre-crisis levels.
The Economist (2011) suggests that it is unlikely for smaller countries to seat at the top of the table. However, it will be possible for them to maintain their Euro Zone membership. A major shortcoming of the study is that it is limited only to Euro zone countries due to time constraints. Another study including the U.K and other non-Euro Zone economies such as Denmark and Sweden will be desirable. This can be treated as an important area for further research.
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Performance Evaluation of the European Bond Market. (2019, Apr 19). Retrieved from https://phdessay.com/performance-evaluation-of-the-european-bond-market-analysis-of-the-yield-spreads-on-10-year-government-bonds/