Mispricing of debt expansion in the eurozone sovereign credit market

Abstract

We find evidence consistent with risk mispricing in the eurozone sovereign credit market for crisis and non-crisis countries alike, using a novel variable of sovereign debt expansion (DE) that we construct. Even though DE predicts increased default probability, panel regressions from 2002–2017 show a negative association with premia, even when controlling for risk appetite and the known determinants of sovereign premia. The negative association is only briefly interrupted by the 2010 Deauville Summit as expected, but it resumes by the onset of the 2011 eurozone crisis. The introduction of quantitative easing in 2015 mutes the negative association, therefore raising the
concern of what will happen once quantitative easing ends. Our finding is robust to several model specifications.

Keywords: CDS spreads, risk premia, debt expansion, sovereign debt, Quantitative easing.

JEL Classification: E52, E58, G41, H30, H63