Financial markets and investor behaviour in times of stress in euro area sovereign bond markets
Published as part of the Financial Stability Review, November 2024.
This box explores financial market reactions and investor behaviour during episodes of stress in euro area sovereign bond markets. In view of elevated levels of sovereign indebtedness in several euro area countries, financial markets have become increasingly sensitive to macroeconomic and political news. Consequently, recent episodes of widening bond spreads have led to renewed concerns about financial stability related to sovereign risk. Against this backdrop, the analysis below evaluates the shifts in financing conditions for both sovereigns and non-financial corporations, as well as changes in the sovereign bond holdings of domestic and foreign investors following a sovereign stress shock.[1]
Chart A
Financing conditions for sovereigns and firms deteriorate after sovereign stress events, while financial and political uncertainty increase
a) Five-year sovereign CDS premia for selected euro area countries | b) Impulse responses of financial variables to euro area-wide sovereign stress events |
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(Jan. 2015-Nov. 2024, basis points) | (percentages, * = right-hand scale) |
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Sources: CMA, Bloomberg Finance L.P., ECB and ECB calculations.
Notes: Panel b: the figure shows the estimated impact of a 1 standard deviation euro area-wide sovereign stress shock on financial variables. The sample covers the period from January 2007 to December 2023. The dots indicate the peak or trough effect within the first six months after the shock. The sovereign stress shock is proxied by the monthly change in the CDS spread between countries which are more vulnerable to market scrutiny (“Under stress”) and countries which are less vulnerable to market scrutiny (“No stress”), purged from other macro-financial determinants of sovereign risk. The key identification assumption is that sovereign stress – but not other macro-financial shocks – drives changes in the CDS spread. It can be demonstrated that the largest spikes in this series can indeed all be attributed to unexpected events relating to elections and episodes of political uncertainty. The effects of sovereign stress shocks are estimated using country-level panel local projections, which include as control variables one lag of the dependent variable, lags of the euro area one-year sovereign bond rate and the logarithms of industrial production and consumer prices. To control for macro-financial drivers of sovereign risk other than euro area-wide sovereign stress shocks, we include lags of differentials in the sovereign composite indicator of systemic stress and year-on-year industrial production growth. Red (yellow) dots indicate responses in countries under stress (not under stress), while blue dots indicate euro area wide responses. Bars around the dots indicate statistical significance at the 10% level, based on Driscoll-Kraay standard errors. “10y sov. rate” denotes the average ten-year sovereign yield of two country groups. EPU stands for the economic policy uncertainty index for Europe as set out in Baker, S., Bloom, N. and Davis, S., “Measuring Economic Policy Uncertainty”, The Quarterly Journal of Economics, Vol. 131, Issue 4, November 2016, pp. 1593-1636.
Sovereign stress peaked during the EU sovereign debt crisis, but there have also been more recent bouts of volatility. Using CDS premia as a proxy for sovereign stress indicates that various countries have come under sudden market scrutiny over recent years (Chart A, panel a). The most significant spikes in these series often occur around unexpected events, such as the onset of the COVID-19 pandemic or episodes of political uncertainty related at times to election outcomes. Country-specific events frequently propagate to other euro area countries through contagion effects. In this analysis, euro area countries are categorised based on their historical vulnerability to sovereign stress and the contagion effects that follow.[2]
Financing conditions in countries under market scrutiny deteriorate after sovereign stress events, while overall market volatility and policy uncertainty increase. Following a sovereign stress event, sovereign bond yields rise significantly and persistently in countries which are more vulnerable to market scrutiny (“under stress”). By contrast, yields in euro area countries which are less vulnerable to market scrutiny are unaffected (Chart A, panel b). Stock market indices decline consistently in both country groups, indicating that sovereign stress events have a negative impact on firms’ financing conditions across the entire euro area. Financial market volatility and risk aversion (as measured by the SMOVE and VSTOXX indices) increase, as does economic policy uncertainty. At the same time, the euro depreciates against the dollar. Overall, these findings suggest that sovereign stress events trigger widespread uncertainty and a general deterioration in investor risk sentiment.
Chart B
When sovereign stress events occur, investment funds and global investors withdraw from euro sovereign debt markets, while domestic investors step in
Impulse responses to sovereign stress shocks of holdings of sovereign debt from countries subject market scrutiny, by investor type and holder area
a) Immediate response within first quarter | b) Average response within first year |
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(€ billions) | (€ billions) |
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Sources: ECB (SHS), CMA, Bloomberg Finance L.P. and ECB calculations.
Notes: The chart shows the effects across investors of a euro sovereign stress shock of 1 standard deviation on holdings of sovereign debt from countries vulnerable to market scrutiny, on impact (panel a) and for the average effect over the first four quarters (panel b). Blue (yellow) bars indicate point estimates for all (only domestic) holders. The striped bars indicate that effects are not statistically significant at the 10% level. The estimates are obtained from weighted holder-country ISIN panel local-projection regressions run separately for each holder sector. Weights are given by the average holdings at country level over the sample period from Q4 2013 to Q4 2023. The control variables are the same as those in Chart A, panel b. Standard errors are clustered at the issuer-country-time level. Euro area holder sectors: B stands for banks; HH stands for households; IC stands for insurance corporations; IF stands for investment funds; PF stands for pension funds; ROW stands rest of the world (non-euro area).
Investors significantly adjust their debt holdings from countries under market scrutiny following sovereign stress events. Investment funds and investors from the rest of the world (including global hedge and investment funds) are the primary sellers of debt when such events occur (Chart B). This means these investors can amplify the procyclical effects of sovereign stress events on financial markets, while also acting as a disciplining force. Notably, most of the bonds sold are absorbed by domestic investors, with banks being the primary buyers in the short run (Chart B, panel a) and households and insurers stepping in over the medium term (Chart B, panel b). Given that investment funds and foreign investors are holding increasing amounts of euro area sovereign debt, these findings suggest that fiscal policy needs to account for potentially growing volatility in the investor base for such debt.[3] Moreover, the shift towards domestic investors in times of stress reinforces the well-known nexus between governments on one side and banks and insurers on the other. As diversifying the investor base can mitigate the risks associated with overreliance on specific investor groups and reduce the likelihood of market fragmentation during periods of stress, further efforts to complete the capital markets union appear warranted.
International portfolio adjustment and changes in bond holdings of different types of investors have been studied extensively. See, for example, Galstyan, P. and Lane, P.R., “Bilateral portfolio dynamics during the global financial crisis”, European Economic Review, Vol. 57, January 2013, pp. 63-74, and Timmer, Y., “Cyclical investment behavior across financial institutions”, Journal of Financial Economics, Vol. 129, Issue, 2, August 2018, pp. 268-286.
The vulnerability of some countries to sovereign stress has changed significantly over time. In view of the historical perspective taken in this analysis, the following countries are categorised as subject to more market scrutiny: Ireland, Greece, Spain, Italy, Cyprus, Portugal, Slovenia, Slovakia and Slovenia.
Although the market footprint of investment funds and foreign investors declined when the Eurosystem was making positive net asset purchases, these investors started returning to euro area sovereign bond markets after 2022. On this topic, see also the box entitled “Sovereign bond markets and financial stability: examining the risk to absorption capacity”, Financial Stability Review, ECB, November 2023.