Sovereign Credit Quality and Violations of the Law of One Price

Abstract

It is well-documented that government bonds with almost identical cash flows can trade at different prices. This paper analyzes the cross-section of bond spreads across developed European countries and documents a novel result. In periods of widening credit spreads, bond spreads between new and old issues tighten for low quality sovereigns. In other words, the newer bonds become cheaper, not more expensive, relative to their older counterparts. We offer an explanation based on price pressure and provide empirical support using data on net flows of investors in sovereign bonds.

Keywords: Liquidity, International Bond Pricing, Financial Crisis, Euro Crisis, Arbitrage

JEL Classification: F30, G12, G15, G01