Jens Thomsen: European bond markets before and after the euro
Speech by Mr Jens Thomsen, Member of the Board of Governors of the National Bank of Denmark
and Chairman of the EFC-subcommittee on EU Government Bonds and Bills Markets, at the
European Government Bond Summit, Brussels, 25 October 2006.
* * *
My remarks will focus on reflections related to the integration process that the European bond markets
has experienced in the post-EMU era. In particular, I will highlight the successful evolution of
European government bond markets following the introduction of the common currency.
The establishment of the European Monetary Union on January 1, 1999, paved the way for a more
integrated European bond market. In the pre-EMU era, different euro area countries' government bond
yields differed substantially. As an example, yield spreads against Germany in the 10-year
government bond segment ranged up to 700 bp in the 1990's (see slide 1). Yield spreads were
however expected to decline along with the introduction of the euro primarily due to the elimination of
exchange rate risk.
Prior to 1999, attempts were made to anticipate the magnitude of the post-1999 yield spreads
between EMU member states. Sparsely evidence from other currency areas provided some insight in
relation to such anticipations. The provincial bond market in Canada was one such candidate area to
use for comparison as the Canadian provinces had some similar characteristics to the forthcoming
EMU countries, including no explicit rules for mutual or federal bail out. The spreads between bonds
issued by different Canadian provinces and Canadian government bonds were much lower than euro
area spreads prior to the euro ranging "only" up to 60 bp. Notwithstanding declining spreads, the
Canadian evidence indicated that the euro area spreads would not completely disappear (see
slide 2).1
Considering the post-1999 era in retrospect, the euro area spreads have indeed declined significantly
since the introduction of the euro (see slide 3). In fact, euro area spreads are small today and actually
lower than the ones observed between Canadian provinces. This may be due to a higher level of
liquidity in the EMU countries' issues as well as somewhat better credit ratings among EMU countries.
Regarding the credit ratings, they may be influenced by the generally larger tax bases of central
governments in addition to lower labour mobility in Europe which causes tax bases to be more secure.
The convergences of yields among euro area countries have not yet been observed as markedly for
the 10 new EU member states even though ERM2 members clearly have experienced lower spreads
(see slide 4, Lithuania and Slovakia are ERM2 members).
The large decline in the euro area yield spreads reflects the increasing integration of European fixed
income market that has taken place since 1999. The market integration process can be viewed from
four dimensions.
Firstly, the fact that the European government bond market consists of many issuers contrary to the
corresponding US market implies that the European market is more divided per se. However, the
development of a comprehensive network of electronic trading platforms has mitigated this issue, i.e.
the predominant part of the EMU issuers is today connected by the same system (see slide 5).
Secondly, the establishment of primary dealer networks in all EMU countries has, among other things
(e.g. securing liquidity), enhanced the integration of the bond market. A quick glance at various EMU
countries' lists' of official primary dealers, shows that a large part of primary dealers are present in
almost every government bond market, indicating a high level of market integration across countries
(see slide 6).
Thirdly, a harmonization of market conventions as well as national tax treatments has occurred since
the introduction of the euro. E.g. conventions in government bonds and T-bills markets concerning
settlement date, definition of business days and day count basis, coupon frequency and coupon
calculation methods are almost completely harmonized across euro area countries today (see slide 7
and 8). This has made the European fixed income market more transparent and accessible for
international investors.
Fourthly, product development has also contributed to the market integration process. For example the
euro-denominated interest rate swap (IRS) market has grown to become the largest in the world in
absolute terms. In relative terms, the euro-denominated IRS market is today about twice the size of
the USD-denominated IRS market (see slide 9). As a result of the very liquid IRS market, fixed income
instruments across the euro area are today typically priced using the standardized euro swap curve in
combination with yield curves stemming from heterogeneous government bonds. Consequently, the
euro-denominated IRS market has obtained a similar benchmark role as the one held by US treasuries
in the USD-denominated market, with respect to the pricing of fixed income instruments. The
emergence of a liquid swap curve has thereby served to further alleviate the issue of fragmentation in
the European fixed income.
The small yield spreads that still exist today between EMU member states are primarily attributable to
differences in liquidity and credit risk between issuers. Consequently, the EMU era has drawn more
attention to these two factors. Regarding credit risk, increased focus may have served to increase the
disciplinary effect of the financial markets on policy makers. An inspection of the relationship between
the development of national debt-to-GDP ratios and sovereign yield spreads relative to Germany 1999
- 2006, indicates that the improved creditworthiness of the EMU member states since 1999 can
explain some of the decline in the spreads (see slide 10). However, credit risk is only one of the
factors that determine the size of the spreads and should therefore not be viewed in isolation.
In order to examine the role of respectively credit risk and liquidity embedded in the current yield
spreads across EMU countries, one may use prices on credit default swaps (CDS) to split up the yield
spread between credit risk and liquidity. The fact that the price of a CDS approximately equals the
credit risk premium of the underlying bond makes this possible.
Under the assumption that the yield spread between the EMU-members purely can be explained by
differences in credit risk and liquidity, the liquidity risk premium may be defined as the residual of the
yield spread after deducting the credit risk premium (see slide 11). The calculation shows that the yield
spreads today only are affected noticeable by credit risk for Greece, Italy and Portugal, whereas
liquidity primarily plays a role for the smaller issuers.
In addition to the government bond market, the introduction of the euro also formed expectations
concerning a development of the euro-denominated corporate bond market. Though this market has
increased fairly much in terms of total outstanding in the post-1999 period, the corporate bond market
continues to account for a small fraction of the euro-zone debt market (see slide 12). Corporate
finance traditions in Europe favouring the banking model may be one explanation for this. It should be
recognised that well developed mortgage markets make a strong contribution to debt security markets
in a number of European countries.
Nevertheless, an increasing number of entities outside the euro-zone issue bonds denominated in
euro. Indeed, the role of the euro in the international debt security markets has increased substantially
since 1999. For broadly defined international debt securities (i.e. securities either issued outside the
respective currency area or issued within the currency area and targeted at the international financial
markets), the euro account for a global share of 47 percent compared with a share of 37 percent for
the US dollar. The euro's share has risen by 18 percentage points since January 1999. The high share
of the international market compared to the size of the national segment reflects the high relative
importance of the international financial markets for the euro (see slide 13).
The establishment of well functioning European government bond markets is an important contribution
to the European single market supporting an efficient allocation of resources and economic growth.
The contribution from the government bond market in the euro area should therefore not be
underestimated.
BIS Review 122/2006
BIS Review 122/2006
BIS Review 122/2006
BIS Review 122/2006
BIS Review 122/2006
BIS Review 122/2006
BIS Review 122/2006