How Does Sovereign Bond Market Integration Relate to Fundamentals and CDS Spreads?

Abstract

There is significant heterogeneity in the degree and dynamics of sovereign bond market integration across 21 developed and 18 emerging countries. We show that better spanning can significantly enhance market integration through local risk premia dissipation. Integration of the sovereign bond markets increases on average by about 10%, when a country moves from the 25th percentile to the 75th percentile as a result of higher political stability and credit quality, lower inflation and inflation risk, and lower illiquidity. The 10% increase in integration leads to, on average, a decrease in the sovereign cost of funding of about 1% per annum.

Keywords: CDS spreads, credit quality, currency risk, liquidity, macroeconomic risk, political risk, sovereign bond market integration, sovereign funding cost.

JEL Classification: G15, G12, E44, F31, C5.