“Measuring Sovereign Bond Spillover in Europe and the Impact of Rating News”

Interdependence has been commonly studied for stock or exchange rate markets. The recent European sovereign deft crisis shifted interest to sovereign bond markets. Although there is by now strong evidence that sovereign risk premia are driven by a common factor, little is known about the detailed linkages between sovereign bond markets. To fill this gap, we analyse bilateral linkages between EU sovereign bond markets over time, using the forecast-error variance decompositions from a VAR with daily data since 2000 on sovereign bonds yield spreads of EU countries. This framework allows measuring the spillover from shocks to a specific sovereign bond market to other markets. Our results indicate that spillover has substantially increased since 2007. However, there is a lot of heterogeneity in the bilateral spillover sent and received between specific sovereign markets. Spillover is more important than domestic factors for all EMU countries. While the CEE countries affect each other mutually Denmark, Sweden, and the UK are insulated from the impact of other EU countries. Further, we extend the previous event-study evidence on sovereign rating news and analyze the dynamic linkages between sovereign spreads and sovereign ratings actions in our VAR framework. We find that overall effect of ratings news on sovereign risk premia is limited, which is consistent with the claim that most rating action do not come as surprise for the markets. Yet, the rating spillover is very heterogeneous; in particular, it is substantially stronger for downgrades, especially in the lower rating scale. Interestingly, the impact is often stronger on bond spreads of other sovereigns than domestically.