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

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. We employ the VAR method by Diebold and Yilmaz (2009) to analyse the strength and direction of bilateral linkages between EU sovereign bond markets using daily data on sovereign bond yield spreads and a common factor. The forecast-error variance decomposition of this FAVAR indicates a lot of heterogeneity in the bilateral spillover sent and received between bond markets. Spillover is more important than domestic factors for all eurozone countries. The CE countries mostly affect each other. Only Denmark, Sweden and the UK are rather insulated from spillover. The spillover has increased substantially since 2007, despite starting from a high level. We use this framework to measure the impact of sovereign rating news and analyse the dynamic linkages between spreads and the ratings of the main credit rating agencies. We find a two-sided relation between rating news and sovereign risk premia. The spillover of rating news is very heterogeneous, and it is substantially stronger for downgrades at lower grades. The impact is often weaker domestically than on bond spreads of other sovereigns.