Liquidity interactions in credit markets: An analysis of the Eurozone sovereign debt crisis

At the end of 2009, countries in the Eurozone began to experience a sudden divergence of bond yields as the perceived prospect of sovereign default risk increased. This paper examines the potential spillovers between the liquidity of the sovereign credit default swap (CDS) market and the liquidity of the sovereign bond market for a group of Eurozone countries. Empirically, we consider the differential spread on various Eurozone members sovereign bonds over the equivalent German benchmark. Using a unique dataset, constructed from the tick by tick transaction history from the 5-10 year maturity of the sovereign bond and CDS markets, we find that for countries such as Portugal, Spain and Ireland, the CDS market reveals a growing influence on bond yields post 2009. We provide substantial evidence that Greek sovereign CDS spreads and debt spreads do not exhibit the same time varying correlative patterns. Furthermore, we suggest that CDS spreads and bond credit spreads for Greek debt have correctly priced the default risk and that the trend patterns observed have not been substantially affected by changes in the liquidity profiles of either market. On a general note, we show that the bond yield liquidity spreads have increased substantially over the 2007-2010 period whilst CDS liquidity spreads have fallen dramatically. For some countries, such as Portugal, liquidity risk plays an important role in the sovereign bond market.