Government bond yield spreads determination: a matter of fundamentals or market overreaction? Evidence from over-borrowed European countries

This paper examines through a panel data analysis the determinants of government bond yield spreads for over-borrowed European countries (Belgium, Italy, Ireland, Greece, Portugal, Spain) for the period 1990–2010. The results suggest that the aforementioned government bond yield spreads were significantly increased during international financial crises. On the other hand, domestic macroeconomic fundamentals appear to be negligible drivers of government bond yield spreads for the same period. A high debt-to-GDP ratio seems to be an important determinant of spreads only after 2007, when the subprime mortgage crisis had burst out and market sentiment became negative. Thus the paper presents some evidence that sharp bond spread fluctuations may be driven by financial markets' overreaction and investors' herd behaviour during international financial crises. Financial markets seemed to neglect the deterioration of macroeconomic fundamentals of the six European countries during tranquil periods and seemed to start discriminating more, between countries, during crises.