The Determinants of Sovereign Bond Yield Spreads in the European Debt Market: Discounting the Fixation on Country Fundamentals (2023)

Undergraduate: Nicholas Carney

Faculty Advisor: Klara Peter
Department: Economics

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There have been significant fluctuations in the relative yields of European sovereign debt in the 2001-2022 period. During the period preceding the Sovereign Debt Crisis, yields on sovereign bonds in most European countries were moving very close together, with the Eurozone countries achieving almost perfect convergence. At the onset of the Sovereign Debt Crisis, there was a significant divergence in sovereign bond yields, and reconvergence to the pre-crisis level has not since been achieved. Variations in yield spreads lead to tightening economic conditions and ineffective transmission of monetary policy for Eurozone countries. In this paper, I investigate the drivers of the yield spread, and the implications my results have for effective policymaking to mitigate the spread. I find that VIX, the surplus as a percentage of GDP, and real GDP growth are the primary drivers of the yield spread. Additionally, the sensitivity of the yield spread to various risk indicators changes in response to crisis periods, and yield spreads for countries with a relatively low real GDP per capita are more sensitive to shifts in international financial risk. These findings reveal the shortcomings of the fiscal policy that had been implemented during the Sovereign Debt Crisis that focused heavily on improving fundamentals, given the importance of international risk aversion and economic growth in driving the spreads.

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