Sovereign Debt Risk Premium

After the completion of this module students will be able to:
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how the sovereign debt risk premium changes in value over time.
4. Assess the impact of the 2008-2009 financial crisis on European economies.

Ideally, this module should be directed to a financial economics class. It can be used as either (a) an instructor-led example in a large lecture or (b) student groups can be assigned to replicate it outside of class as a basis for a short assignment. Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on the factors that drive the assessment of sovereign bond default risk and how their evaluation changes, sometimes rather dramatically, over time.

Note that a more advanced treatment of this topic may compute the sovereign bond risk premium between countries at different stages of economic development. These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct.

Prerequisite skills: Graph literacy
Prerequisite concepts: Bond yields; Sovereign risk; Risk premium

The following is a description of this activity being used as an instructor-led example. For a basic step-by-step description of this activity –also suitable for a student-led exploration of the topic– please see the Handout Activity Handout for Sovereign Debt Risk Premium (Microsoft Word 26kB Jun27 14).

Within a lecture discussing bond prices or interest rates, an instructor will use this module to help students understand the concepts of sovereign debt risks and risk premiums and to guide a discussion of their quantification.

(Step 1) The instructor will first present a graph of the Interest Rates, Government Securities, Government Bonds for Spain (INTGSBESM193N) (Category: International Data > Countries > Spain > Interest Rates, Government Securities, Government Bonds)

The instructor should point out the two markedly different value ranges of the series: pre-1998 and post-1998. Narrowing the range of the data set to 1990-present will make that pattern more obvious. Special attention should be paid to the fact that the bond yield increased in value around 2010. This fact will become relevant when introducing an additional data series.

The instructor can ask students to review the relationship between bond yield and bond price, discussing potential reasons for why yields on Spanish sovereign debt dramatically decreased ahead of the introduction of the Euro. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.

(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the Interest Rates, Government Securities, Government Bonds for Germany (INTGSBDEM193N) (Category: International Data > Countries > Germany > Interest Rates, Government Securities, Government Bonds)

The instructor should point out that although there is general co-movement between the series German sovereign debt has traditionally offered lower yields than Spanish sovereign debt. The instructor can ask students to put forward an argument for why that is the case. Thus having introduced the concept of sovereign debt risk premium, discussion should turn to the extraordinary convergence in yield values between 1998 and 2008, and to their divergence after 2008.

(Step 3)
The instructor will then "Edit Data Series 2" (Interest Rates, Government Securities, Government Bonds for Germany (INTGSBDEM193N)) by deleting it [click on trash can icon to the right of the series' name].

Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing Interest Rates, Government Securities, Government Bonds for Germany (INTGSBDEM193N) (Category: International Data > Countries > Germany > Interest Rates, Government Securities, Government Bonds)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > a – b > Apply"

The graph now plots the difference between Spanish sovereign debt and Germany sovereign debt, a computation of sovereign debt risk premiums.

The following is a list of questions that could be asked:
- Why would the introduction of a single currency in the European Union reduce the sovereign debt risk premium between Spain and Germany? What are the implications of such a change on the financing of Spanish government deficits?
- How did the 2008-2009 financial crisis affect the sovereign debt risk premium between Spain and Germany? Should you revise your answer to the previous question? What are the implications of such a change on the financing of Spanish government deficits?

Further sophistication:
- Plot the difference between the Interest Rates, Government Securities, Government Bonds for Italy (INTGSBITM193N), Interest Rates, Government Securities, Government Bonds for France (INTGSBFRM193N), and the Interest Rates, Government Securities, Government Bonds for Germany (INTGSBDEM193N). Compare with the previous graph. Discuss how and why the sovereign debt risk premiums are different.

The Federal Reserve Bank of San Francisco's Economic Letter "Convergence of Long-Term Bond Yields in the Euro Area" (see full reference under Resources) discusses the evolution of sovereign debt risk premiums prior to the introduction of the Euro. This letter was written before the 2008-2009 financial crisis and is a great resource to carry the discussion further.

The popular press abounds in assessments of sovereign risk. These can be used to provide more poignant context. An example is "Italy, Spain Close the Risk Divide" (see full reference under Resources).

The recommended method for assessment for a financial economics class would be to have students write up a short memo where they discuss the historical evolution of sovereign debt risk premiums computed as the difference between high-yield and low-yield sovereign bonds. This should be a take-home assignment.

"Convergence of Long-Term Bond Yields in the Euro Area" by Eric T. Swanson
Federal Reserve Bank of San Francisco Economic Letter 2008-37, November 21, 2008
http://www.frbsf.org/economic-research/files/el2008-37.pdf

"Italy, Spain Close The Risk Divide" by Nick Cawley and Neelabh Chaturvedi
Wall Street Journal (WSJ.com) March 5, 2013
http://online.wsj.com/news/articles/SB10001424127887324539404578340561434301772