CHAPTER 12

Integration of the European Government Bond Markets

The establishment of the Economic and Monetary Union (EMU) on 1 January 1999 paved the way for greater integration of European government bond markets. Prior to the introduction of the euro, yields on government bonds varied greatly among the future euro area member states, primarily as a result of exchange-rate risk. Parallel with the introduction of the euro, a market-driven integration process has taken place. For example, market conventions have been harmonised among European issuers, and international electronic trading platforms have become more widespread.

In addition, the market for euro-denominated interest-rate swaps has developed considerably, and today, fixed-income securities in the euro area are typically priced on the basis of this market. In this way, the national government bond markets are interconnected. The integration of the bond markets has contributed to reducing yield spreads across the euro area. The narrow yield spreads still existing today, are primarily attributable to differences in credit risk and liquidity among the euro area member states.^[1]

12.1 NARROWING OF YIELD SPREADS

Prior to the introduction of the euro, the European government bond markets were characterised by relatively large differences in yields. For example, yield spreads vis-à-vis Germany ranged up to 700 basis points in the 1990s, cf. Chart 12.1.1.^[2] A number of factors contributed to the considerable variation in yield spreads. One of the most important was uncertainty regarding future exchange-rate fluctuations. Moreover, there were also differences in market conventions, public regulation such as investment rules^[3], varying taxation rules, credit risk and liquidity.

With EMU, exchange-rate fluctuations within the euro area have been eliminated and progress has been made in harmonising national tax rules. In addition, the introduction of the euro, combined with technological advances, has stimulated a market-driven integration process. As a result, European yield spreads have narrowed considerably, and today are attributable primarily to differences in liquidity and credit risk.

12.2 MARKET-DRIVEN INTEGRATION

Intensified competition
The introduction of the euro gave investors easier access to financial markets within the euro area. This reduced the home bias^[4] of investors, thereby increasing diversification within the euro area. Furthermore, technological advances have created new distribution channels and increased competition between issuers of financial products. Today issuers therefore to a greater extent compete for the same pool of investors. The competition has contributed to increased harmonisation of market conventions in the euro area due to incentives for issuers to adjust the market structure in order to attract more investors.

Market conventions
A harmonisation of market conventions has taken place among euro area countries in the market for government bonds and T-bills. For example, settlement date and day-count conventions have now by and large been harmonised across the euro area, cf. Table 12.2.1. This has made the European bond market more transparent and thus more accessible for international investors.

It is important to emphasise that the harmonisation could have taken place without EMU, but in connection with the transition to the euro it was natural to harmonise the market conventions as well. The harmonisation of market conventions thus went hand in hand with the introduction of the euro.

Liquidity dispersed among many issuers
Compared to the USA, there are many issuers of government bonds in the euro area. The large number of outstanding bond series, combined with varying credit ratings for issuers, makes the European market more fragmented than the US market. This sets limitations to liquidity, while also increasing the need for trading information.

As a result, coordinated issuance has been considered to bring together liquidity from several member states. In 2000, the European Commission published the Giovannini Group's report, " Co-ordinated Public Debt Issuance in the Euro Area" .^[5] The report pointed out that joint issues could be an advantage for the small member states in particular since higher liquidity premiums could reduce their costs. The report examined four initiatives that, to different degrees, would lead to increased coordination of government debt policies, cf. Box 12.1.

Today, a certain degree of coordination of technical aspects is seen among European issuers, cf. the EFC Sub-Committee on EU Government Bonds and Bills Markets (the Thomsen Group).^[6] However none of the other initiatives have been implemented. The intensified market integration, since the publication of the report, has reduced the problem of split liquidity.

The interest-rate swap market
The European interest-rate swap market has increased more than fivefold since the introduction of the euro, measured by outstanding volumes. Relative to the outstanding volume of fixed-income securities, the euro-denominated interest-rate swap market is now twice as large as the dollar-denominated interest-rate swap market, cf. Chart 12.2.1.

The euro swap curve is used as the reference for the pricing of bonds since it is independent of coupon size and based on an average of the credit ratings of the most creditworthy banks. This means that the curve is not dependent on the credit rating of a single issuer.^[7] In view of the ample liquidity in the market for euro-denominated interest-rate swaps, fixed-income securities in the euro area are now typically priced on the basis of the standardised euro swap curve.

The euro-denominated interest-rate swap market has thus achieved the same status as US government securities in the dollar-denominated market in terms of the pricing of fixed-income securities and interconnects the national European markets for government securities.

Electronic trading platforms
Today, the electronic trading platforms constitute a network that links the European government bond issuers. For example, Danish bonds are traded at MTS^[8], TradeWeb, Bloomberg, Bondvision, Reuters and ICAP/BrokerTec, which are electronic trading platforms also operating across the euro area. Most of the issuers in the euro area member states are connected to the same trading platforms. The increase in electronic trading has contributed to reducing the costs of trading government bonds, while also supporting liquidity.

Primary dealers
Most euro area member states have now established a network of primary dealers, i.e. financial institutions with the right to purchase government bonds on issue. Up to the launch of EMU there was a general tendency to internationalise the group of primary dealers in the various countries. Today the euro area member states use a combination of national and international financial institutions as primary dealers. This has accelerated the integration of the government bond markets because primary dealers operate across the euro area. The largest international banks are present in virtually all euro area member states, cf. Table 12.2.2.

The introduction of electronic trading platforms, and the stand­ardisation of market conventions, also enable dealers to operate in several national markets, which enhances familiarity with all markets. At the same time trading costs have been reduced. Furthermore, the presence of the primary dealers has helped to secure liquidity in the government securities.

12.3 ANALYSIS OF FINANCIAL INTEGRATION

In an integrated market without any barriers to international investment, bond yields will to a greater extent react to information that is relevant for the entire integrated market.

One measure of the degree of financial integration is the extent to which yield movements in the euro market is reflected in the yield on government bonds issued by a given country. The German government bond market is used as the euro area reference in the analysis. The analysis below therefore assesses the degree to which the change in the 10-year German bond yield can explain fluctuations in yields in the sovereign bond markets, cf. Box 12.2.

Increased financial integration entails that the estimated a-values in the regression in Box 12.2 converge towards zero, since interest-rate fluctuations in one country should not be systematically larger or smaller than the changes in the reference. The development in the estimated α-values is illustrated in Chart 12.3.1, which thus illustrates the integration process over time. It is seen that the estimated a-values were volatile until 1999, after which they are approximately zero. After 1999 the Danish α-values are more volatile than those of the euro area member states.

Increased financial integration also entails that the estimated β-values converge towards 1, since this implies that interest-rate changes across the integrated market are driven by the same factors. Chart 12.3.2 shows that the estimated β-values rose substantially in 1999 when the euro was introduced, and have subsequently converged towards 1.

12.4 EXPLANATION OF CURRENT YIELD SPREADS IN THE EURO AREA

Yield spreads still exist between the euro area member states. On average, the euro area yield spreads have narrowed by 14 basis points since 1999, to a current average of 7 basis points. However, Greece, Italy and Portugal still have double-digit yield spreads, which in fact have widened in recent years. This reflects that since 2004 the budget deficit as a ratio of GDP has exceeded 3 per cent in all three countries.

In view of the single currency and the high degree of market harmonisation, the current yield spreads are primarily attributable to variations in liquidity and credit risk among issuers. This virtually also applies to Denmark due to Denmark's fixed exchange-rate policy vis-à-vis the euro.

Credit risk
Credit risk is the risk of a financial loss as a consequence of the bond issuer's default on its payment obligations. The higher the credit risk, the greater the additional return required by investors for holding the bond in question.

The credit risk on a government bond depends primarily on the issuer's debt ratio and the tax base. For example, a higher debt ratio will make government finances more exposed to cyclical fluctuations and changes in interest rates, which increases the risk that the debt is downgraded.^[9] Downgrading often coincides with a widening of the spread, and thus a capital loss.

In general, recent years have seen very small variations in yield spreads compared with differences in fiscal-policy conditions. However, the relation between the development in yield spreads and in the debt-to-GDP ratio is positive, cf. Chart 12.4.1. For example, Denmark's gross government debt as a ratio of GDP declined 29 percentage points in the period 1999-2006, while Germany's debt rose by 7 percentage points. Denmark's debt thus declined by 36 percentage points of GDP relative to Germany. In the same period, the Danish yield spread vis-à-vis Germany narrowed by 42 basis points.

Liquidity
Liquidity depends on the size and trading volume of the bond issue, among other factors. A high level of liquidity makes it possible for investors to sell assets without influencing price formation.

Increased competition among government issuers has increased the focus on achieving sound liquidity in the bond series issued. This should be viewed against the fact that even in the short term government debt offices can improve liquidity in government securities. On the other hand, the market's perception of credit risk is more difficult for the issuer to influence since the credit risk is primarily dependent on the general fiscal-policy development. The focus on liquidity has led to strategy adjustments in several EU member states. For example, there has been a tendency for the government bond market to concentrate issues on fewer, but larger series.^[10] This creates the conditions for substantial liquidity and thereby lower financing costs.

The bid-ask spread for a bond, i.e. the cost of purchasing a security and then selling it immediately after, is an indicator of liquidity.^[11] Chart 12.4.2 shows that since the introduction of the euro the average bid-ask spreads have narrowed.

The narrowing of the bid-ask spreads indicates that liquidity has generally improved in the period. However, liquidity still has an impact on European yield spreads. Empirical studies have shown that liquidity is particularly important for countries with low credit risk, and in periods of high uncertainty in the markets.^[12]

Breakdown of yield spreads by credit risk and liquidity
Chart 12.4.3 presents a breakdown of the average yield spread by respectively credit risk and liquidity in the period from September to December 2006. The credit risk premium is calculated on the basis of prices for credit default swaps (CDS), while the liquidity premium is calculated residually and will thus include contributions from other factors besides liquidity, cf. Box 12.3. Since Denmark has not adopted the euro, the liquidity premium for Denmark will also contain an element of e.g. exchange-rate risk.

Greece, Italy and Portugal are virtually the only member states paying a credit risk premium relative to Germany. Liquidity primarily affects the yield spreads among the small issuers.