Detecting Regime Shifts in Euro Area Government Bond Risk Pricing: The Impact of the Financial Crisis

We investigate the presence of an euro area-wide crisis regime in the risk pricing of euro area government bonds. We investigate how often and when the crisis regime occurs, how long it lasts, and how it affects the importance... [ view full abstract ]

We investigate the presence of an euro area-wide crisis regime in the risk pricing of euro area government bonds. We investigate how often and when the crisis regime occurs, how long it lasts, and how it affects the importance of the components that make up the risk premium of euro area government bonds (i.e. the mean, the country-specific risk factor, and the common euro area-wide risk factor). To this end, a dynamic factor model with Markov switching parameters is estimated using 10 year government bond yield spreads of five euro area countries (Belgium, France, Italy, the Netherlands, and Spain) versus Germany over the period 1999/1 until 2012/4. We identify a permanent regime shift in the pricing of risk during the first half of 2008, i.e. before the Lehman default (September 2008) and well before the outbreak of the government debt crisis in the euro area periphery. Following the regime shift the impact on the spreads of both the country-specific risk factor and the area-wide risk factor is significantly higher in all countries considered. While all countries experience qualitatively similar changes in the risk pricing of their bonds, the magnitude of the changes is different across countries.