The decoupling between public debt fundamentals and bond spreads after the European sovereign debt crisis

Abstract

We contribute to the literature that documents empirically that the relationship between public debt fundamentals and sovereign bond spreads in Spain, France, and Italy (versus Germany) weakened after the 2010–2012 episode of sovereign debt markets’ significant distress. To construct our measure of public debt fundamentals, we build on the literature that combines the Value at Risk approach with the estimation of the correlation pattern of public debt dynamics’ macroeconomic determinants via Vector Auto Regressions (VARs) to estimate the probability distribution of alternative debt trajectories. Since we incorporate in the VAR new information in a sequential manner, we are able to retrieve time-varying probabilities that characterize the expected behaviour of debt at a given point in time in the future. We then empirically confront such probabilistic indicators with market-derived sovereign bond spreads.