The pricing of G7 sovereign bond spreads – the times, they are a-changin

Against the background of the current debate about fiscal sustainability in several advanced economies, this paper estimates the determinants of sovereign bond spreads of the G7 countries, using high-frequency proxies for market expectations about macroeconomic fundamentals. It allows for time-varying parameters and stochastic volatility as well as for asymmetry in the effects of countries’ fundamentals on yield spreads. The paper finds that there is substantial asymmetry in the importance of country fundamentals, which shrinks, the closer the two constituent bonds are to being substitutes. There are also considerable time variations in the role of the various determinants. In particular, there has been a reduced pricing of several risk factors in the years preceding the financial crisis, and either an over-pricing of risk or the pricing of catastrophic events like a break-up of the euro area and a re-denomination risk of euro area bonds during the European sovereign debt crisis.