Abstract - Sovereign Bond Risk Premiums
Credit risk has become an important factor driving government bond returns. We therefore introduce an asset pricing model which exploits information contained in both forward interest rates and forward CDS spreads. Our empirical analysis covers euro-zone countries with German government bonds as credit risk-free assets. We construct a market factor from the ﬁrst three principal components of the German forward curve as well as a common and a country speciﬁc credit factor from the principal components of the forward CDS curves. We ﬁnd that predictability of excess returns of sovereign euro-zone bonds improves substantially if the market factor is augmented by a common and an orthogonal country speciﬁc credit factor. The common credit factor signiﬁcantly contributes to predictability of each country’s government bond risk premiums while the country speciﬁc factor does so only for periphery euro- zone countries. The common European credit factor is positively correlated with a European volatility index and negatively correlated with the Euro stocks index. Finally, we ﬁnd that over the current crisis period, market and credit risk premiums of government bonds are negative, a ﬁnding that we attribute to the presence of ﬁnancial repression in euro-zone countries.
Vienna University of Business and Economics
14. May. 2013