What are the driving factors behind the rise of spreads and CDS of euro-area sovereign bonds? A FAVAR model for Greece and Ireland

摘要

This paper examines the dynamics of selected euro-area sovereign bonds by employing a factor augmenting vector autoregressive (FAVAR) model for the first time in the literature. This methodology identifies the underlying transmission mechanisms of several factors, and in particular, market liquidity and credit risk. Departing from the classical vector autoregressive (VAR) models allows us to relax limitations regarding the choice of variables that could drive spreads and CDS of euro-area sovereign debts. The results show that liquidity, credit risk and flight to quality drive both spreads and CDS of five years maturity over swaps for Greece and Ireland in recent years. Greece, in particular, is facing an elastic demand for its sovereign bonds that further stretches liquidity. Moreover, in illiquid debt markets spreads continue to follow a steep upward trend which is expected to have certain adverse implications for financial stability. We also observe a negative feedback effect from counterparty credit risk.