The European Bond Markets under EMU

531Oxford Review of Economic Policy vol. 20 no. 4 2004© Oxford University Press and the Oxford Review of Economic Policy Limited 2004; all rights reserved.

THE EUROPEAN BOND MARKETSUNDER EMU

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 20, NO. 4DOI: 10.1093/oxrep/grh031

MARCO PAGANOUniversità di Napoli Federico II, CSEF, and CEPRERNST-LUDWIG VON THADDENUniversität Mannheim and CEPR1

In this paper, we document how, in the wake of monetary unification, the markets for euro-area sovereign andprivate-sector bonds have become increasingly integrated. Issuers and investors alike have come to regard theeuro-area bond market as a single one. Primary and secondary bond markets have become increasinglyintegrated on a pan-European scale. Issuance of corporate bonds has taken off on an unprecedented scale incontinental Europe. In the process, both investors and issuers have reaped the considerable benefits affordedby greater competition in the underwriting of private bonds and auctioning of public ones, and by the greaterliquidity of secondary markets. Bond yields have converged dramatically in the transition to EMU. The persist-ence of small and variable yield differentials for sovereign debt under EMU indicates that euro-area bonds arestill not perfect substitutes. However, to a large extent, this does not reflect persistent market segmentation butrather small differentials in fundamental risk. Liquidity differences play at most a minor role, and this roleappears to arise partly from their interaction with fundamental risk. The challenges still lying ahead arenumerous. They include: the imbalance between the German-dominated futures and the underlying cashmarket; the vulnerability of the cash markets’ prices to free-riding and manipulation by large financial institu-tions; the possibility of joint bond issuance by euro-area countries; the integration of clearing and settlementsystems in the euro-area bond market; and the participation of new accession countries’ issuers in this market.

I. INTRODUCTION

The European Monetary Union (EMU) has prob-ably been the single most important policy-induced

1 We thank Giorgio Basevi, Carlo Favero, Gianluca Garbi, Tullio Jappelli, and two anonymous referees for very helpful commentsand suggestions, and Philipp Hartmann, Philippe Rakotovao, and Paolo Volpin for supplying data. Hugo Villacres provided valuableresearch assistance. Both authors are members of the MTS Scientific Committee. The views expressed in this paper do notnecessarily reflect those of MTS or its Scientific Committee.

innovation in the international financial system sincethe collapse of the Bretton-Woods system. It hasopened the possibility for the creation of a new, fullyintegrated continental financial market, of the same

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scale as that of the United States. By eliminatingexchange-rate risk, EMU has eliminated a keyobstacle to financial integration. Before EMU, oth-erwise identical financial claims issued in differenteuro-area currencies were imperfect substitutesand traded at different prices. EMU has eliminatedthis source of market segmentation.

While a single currency is a necessary condition forthe emergence of pan-European capital markets, itis not a sufficient one. Other frictions may still standin the way of full integration: even after the removalof exchange-rate risk, persistent differences in taxtreatment, standard contractual clauses and busi-ness conventions, issuance policy, security tradingsystems, settlement systems, availability of infor-mation, and judicial enforcement may still segmentfinancial markets along national borders.

In the European bond market, however, monetaryunification triggered a sequence of policy actionsand private-sector responses that swept aside mostof the other obstacles to integration. This wasfacilitated by the intrinsically standardized nature ofbonds and by the limited number of issuers in thesovereign bond market. The issuers coincided withthe policy-makers who had promoted EMU, andwere determined to gain in terms of reduced fundingcost from a broader and more liquid market.

While the push towards integration arose in thepublic bond market, it had a powerful spillover effecton the private bond market, where it generated adramatic growth in issuance, secondary markettrading, and competition among underwriters. In thispaper, we describe the emergence of an integratedmarket for public as well as private euro-area bonds,highlighting both the impressive changes that havealready occurred and the reasons why these bondsare still imperfect substitutes.2

We start by illustrating, in section II, the chainreaction of policy actions and private-sector re-sponses that reshaped the institutional frameworkof the sovereign bond market, leading to morehomogeneous issuance and trading arrangements,and show how their effects spilled over into themarket for private-sector bonds. In section III, we

document how these changes fostered conver-gence in government bond yields in the transition toEMU. In section IV, we highlight that, in spite of allthese achievements, euro-area bonds are still im-perfect substitutes, and investigate the reasons andimplications of the remaining yield differentials andof their changes over time. Section V concludes bysummarizing and taking a look at possible futuredevelopments in this market.

II. EMERGENCE OF INTEGRATEDBOND MARKETS IN EUROPE

While the introduction of the euro sparked off bond-market integration, its effects were magnified by itsconcomitance with a worldwide expansion in pri-vate bond issuance, which outweighed the stagnantpublic debt issuance of the 1990s. Indeed, it isprivate-sector issuance that has nurtured the growthof the euro-area bond market in the wake of EMU,and transformed the euro into a leading currency ofdenomination for international bond issues. It seemsappropriate, therefore, to start our account by set-ting European developments in their global context.Our next step is to document how the introduction ofthe euro changed both the behaviour of euro-areaissuers and that of investors. It prodded the formerto compete in the supply of more homogeneoussecurities to a much larger potential market, and thelatter to shift their portfolio selection away fromhome issuers. At the same time, it opened up greatopportunities to trading platforms with pan-Euro-pean capabilities, and to intermediaries willing tocompete for underwriting business on a pan-Euro-pean basis. As we shall see, the response of marketsand intermediaries to this challenge contributed tothe integration of the market, by compounding theresponses of issuers and investors.

(i) The European Market in Global Perspective

Before EMU, European bond markets were largelydomestic and significantly smaller than their UScounterparts. Table 1 gives an overview of the sizeof international bond markets in 1998; in that year,the value of total bonds outstanding in the euro areawas still 56 per cent of the value in the USA. This

2 Danthine et al. (2001), Galati and Tsatsaronis (2001), and Hartmann et al. (2003) provide broader overviews, including othersectors of the financial market.

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size differential existed for both the private and thepublic bond market. However, the euro-area publicand private bond markets taken together alreadyaccounted for 25 per cent of the world total, andwere significantly bigger than their Japanese coun-terparts.

Segmentation along national boundaries was a ma-jor feature of bond markets in Europe. At the startof the 1990s, almost all public debt was still issueddomestically, while for private-sector issues theratio of domestic to international debt securities inEurope was about 4:1. Except for a few public orsemi-public benchmark bonds, such as the 10-yearBund or the German Pfandbriefe, secondary mar-ket activity in Europe also remained largely domes-tic until the late 1990s.

All this changed drastically in the late 1990s. Therewas sustained growth in issuance of bonds world-wide, and Europe shared in this growth of themarket especially with much increased corporate

bond issuance and international debt issuance. Ta-ble 2 shows that global net debt issues increased by65 per cent between 1994 and 1999, and Figure 1(a)indicates that this was mostly driven by the growthin bond issuance by the private sector. This growthoccurred on both sides of the Atlantic, though withslightly different timing.

In the United States, the economic boom of the mid-1990s was accompanied by a strong expansion ofprivate-sector debt issues, with volumes rising from$280 billion in 1994 to $1,061 billion in 1998, asshown by Figure 1(b). Yet, in the aftermath of theLong Term Capital Management and Russian debtcrises, private-sector issues in the USA declinedsharply in 1999 and 2000, before issuing activitypicked up again.

In the euro area, the private-sector debt expansionwas more modest than in the United States in themid-1990s: it rose from $124 billion to $273 billionbetween 1994 and 1998. But, after the introduction

Table 1Size of International Bond Markets in 1998

Total bonds outstandinga Of which: government bonds

USA 11, 656.45 7, 031.77Euro zone 6, 526.42 3, 577.49Japan 3, 958.94 2, 824.40Rest of the world 4, 369.43 2, 229.01World total 26, 511.24 15, 662.67

Note: a By country of origin of issuer, in $ billion, end of third quarter 1998.Source: Bank for International Settlements (BIS), own calculations.

Table 2Global Net Issuance of Debt Securities

Currency/year 1994 1995 1996 1997 1998 1999 2000 2001 2002

US dollar 664.3 796.9 1,125.4 1,255.5 1,726.4 1,511.9 1,053.5 1,302.1 1,443.6Euro 876.4 626.3 562.9 714.0Euro-areacurrencies 425.3 366.3 528.7 326.9 435.3

Yen 336.7 434.6 458.7 237.9 185.8 496.1 450.6 570.6 280.6Other currencies 578.3 544.1 392.6 362.4 438.9 470.7 375.9 450.6 494.3Total 2,004.6 2,141.9 2,505.4 2,182.7 2,786.4 3,355.1 2,506.3 2,886.2 2,932.5

Source: BIS, own calculations.

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of the euro, private issuance more than doubled to$657 billion in 1999, as illustrated by Figure 1(c).Despite the subsequent reduction, euro-area pri-vate-sector issuance later remained much higherthan in the first part of the decade. That the 1999boom is associated with the euro is underscored alsoby the different pattern of private bond issuanceobserved for European countries outside the euroarea (Figure 1(d)), where the growth occurredgradually since 1994, as in the USA.

In Japan, by contrast, private-sector issues werealmost flat in the 1990s, owing to the prolongedrecession. In contrast, public debt issuance in-creased drastically after 1998. This pattern is theopposite to that observed in the USA and Europe,where net government borrowing decreased formost of the period. The spike of public debt issuesin the USA in 1998–9 was exclusively due to strongissuing activity by local governments and the hous-ing finance agencies.

Hence, global bond issuance expanded dramaticallyin the 1990s, in three different areas: first, USprivate-sector issues in the mid-1990s; second, euro-area private-sector issues after the introduction ofthe euro; and third, Japanese public borrowing after1998. As of 2004, all these three features seemed tobe persistent: between 1999 and 2003, averageprivate bond issuance in the USA was about $900billion, up from $280 billion in 1994; that in the euro-area was about $550 billion, more than four times the1994 level; and Japanese government borrowingaveraged roughly $450 billion, up from an average of$250 billion in 1994–8.

The strong expansion of the euro-area bond marketis reflected in an increase in the importance of theeuro as international issuing currency. Table 2shows no increase in the relative importance of theeuro (or its precursor currencies) with respect to thedollar, but these numbers aggregate domestic andinternational debt issues. Unfortunately, the empiri-cal classification of bond issues in these categoriesis controversial. According to the international sta-tistics of the BIS, the euro overtook the US dollar in1999 as the most heavily used currency for interna-tional debt issues, and has traded the lead in thiscategory with the dollar since then. International

issues, according to the BIS, include all issuesexcept the domestic-currency bonds issued by resi-dents and targeted to domestic investors. However,Detken and Hartmann (2000) have rightly pointedout that these numbers understate the internationaluse of the dollar, because of the global importanceof the US market. They present data on announceddebt issues that take this bias into account and findthat the dollar has remained the most importantinternational issuing currency, although the euro hasdoubled its share in international debt issues be-tween 1994 and 2003.3

(ii) The Supply Side

Public issuesThe fiscal discipline stemming from the MaastrichtTreaty criteria has restrained the total volume ofsovereign bonds issued in the euro area. As shownin Figure 1(c), total public-sector debt issues in theeuro area fell from $414 billion in 1994 to $111 billionin 2000. Recently this process has been partiallyreversed, but despite the de facto scrapping of theStability and Growth Pact in 2003, its remnants canstill be expected to curb the expansion of public debtin the foreseeable future.

Yet, despite this overall restraint on the size of thepublic debt market, the introduction of the euro hasdeeply changed the way in which public debt isissued in Europe. In fact, the changes in issuingpolicy by sovereign issuers went far beyond a simplecurrency conversion.

In 1995, EU governments decided that, as of Janu-ary 1999, all new fungible public debt by EMUmember states should be issued in euros. This wasa direct consequence of the introduction of the euroand in itself would have already created relativelylarge euro markets for long-term public debt. Yet,governments were undecided at the time whether toredenominate their outstanding debt into euros withthe inception of EMU. Redenomination would notonly have added large volumes to the long end of theyield curve, but also created euro markets forshorter maturities. This potentially beneficial effectneeded to be balanced against the costs and techni-cal difficulties of such a switch. The French and theBelgian governments opted very early in favour of

3 We are grateful to Philipp Hartmann for sharing his updated data with us.

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Figure 1Global Bond Issuance

(a) Total net bond issues, worldwide (b) Total net bond issues, USA

(c) Total net bond issues, Euro area (d) Total net bond issues, rest of Europe

(e) Total net bond issues, Japan

Note: Net issues in billions of US dollars. ‘Private sector’ comprises financial institutions and non-financialcorporations; ‘public sector’ comprises central governments, local governments, public-sector firms, andinternational organizations.Source: BIS, own calculations.

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redenomination, whereas the German governmentfor a long time seemed to be undecided. However,mostly for fear of a loss of competitiveness of theFrankfurt bond market, the German ‘Euro Introduc-tion Law’ of June 1998 stipulated the full conversionof existing German fungible federal debt by 1 Janu-ary 1999.4 In the wake of these decisions, all otherEMU countries followed suit soon afterwards.5

The debate about debt conversion was driven by theconcern about the benchmark status of nationaldebt. As in the private debt market, benchmarkstatus confers substantial benefits on the countrythat enjoys it, but a large market size is obviously akey requirement for this status. Therefore, the ‘raceto the benchmark yield curve’ was probably themost important factor in the decisions of govern-ments to redenominate their outstanding public debt.

The competition behind the race for benchmarkstatus was complemented by important cooperativeelements in the development of the European publicbond market. In fact, once the debt conversiondecision was made, governments decided to go onestep further and homogenize bond conventions.Shortly after the introduction of the euro, all membercountries switched the day-count of their outstand-ing and new issues to a common standard, and mostof them switched to using the operating days of theTARGET settlement system as official businessdays for the service of their public debt. Manyprivate bond issuers adopted similar reconventioningplans.6 These changes made public bonds moreeasily comparable and substitutable. While not logi-cal consequences of the introduction of the euro,they show that unification in one area brought aboutby the euro—the redenomination of bonds—en-tailed a further element of unification—thereconventioning.

Subsequently, euro-area governments took severaleven farther-reaching decisions concerning the har-monization of issuing practices, the coordination ofissuing dates, the optimal choice of issuing formats,and similar matters.7 Although more progress is still

possible on these fronts, issuing practices, in particu-lar of smaller euro countries, have changed consid-erably since the 1990s. Pre-announced auctioncalendars have become standard; re-openings andclusterings of issues in different parts of the maturityspectrum have become widely used tools of publicmanagement. In general, issue sizes have increased,with Treasuries buying back old illiquid and/or short-dated bonds and exchanging them for new issuesand concentrating new issues in fewer benchmarksecurities. Some smaller issuers introduced syndi-cated procedures instead of auctions to attract moreinvestors. Moreover, the competition between na-tional Treasuries pushed them to innovate the menuof bonds offered: Spain and France have issuedconstant-maturity bonds; France, followed by otherissuers, has introduced inflation-indexed bonds. Ini-tially, these were indexed to national price indices,but more recently some issues have been indexed toa European price index.

Interestingly, the euro has reached out even into thenon-euro area. For example, the Bank of Englandhas been issuing euro-denominated Treasury Billssince 1999. This broadening of the euro-denomi-nated public debt market has partly compensatedfor the reduction in issuing volumes in most of theeuro-area countries until the early 2000s.

Private-sector issuesAs documented by Figure 1(c), the private bondmarket in Europe experienced a major change in1999, when issuing volumes more than doubled from$273 billion to $657 billion. While the 1998 issuingvolume in the euro area was less than 26 per cent ofthat in the USA, the 1999 volume was more than 74per cent of the US level. Part of this surge probablyreflects exceptional and transient factors. First, thefinancial crisis of late 1998 resulted in catch-upissuing activity in early 1999 (which, however, wasequally relevant for the USA and Europe). Second,the desire to set benchmarks with euro issuespushed issuers to go to the market earlier and inmore concentrated volumes than they might havechosen otherwise. But Figures 1(b) and 1(c) show

4 Except for some short-term obligations, which comprise less than 3 per cent of the fungible federal debt.5 With some minor exceptions such as Austria, which redenominated only the most liquid portion of its tradable debt (34 per

cent).6 For details, see Bank of England (1998). By ‘reconventioning’ we mean changing the terms of legacy transactions to bring them

into line with the new harmonized euro conventions.7 For a discussion, see Favero et al. (1999).

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that a significant part of this change was longer-lived.

The relatively small corporate bond market in Eu-rope until the late 1990s is mirrored by the corre-spondingly greater importance of bank lending.While in the USA bank loans play a negligible rolein the financing of large companies and face strongcompetition from the bond market even for medium-sized companies, they have been traditionally thedominant source of debt financing for almost allEuropean companies, even the largest ones, asshown by Table 3.

This feature of European corporate finance beganto erode in the second half of the 1990s. It is difficultto tell whether the change towards a strongerreliance on bonds has been driven mainly by firms orby the banks themselves. Part of the explanation iscertainly the increasing reluctance of Europeanbanks to provide traditional loans, which inflate theasset side of balance sheets and thus depress keyearnings ratios and require higher regulatory capital.But the introduction of the euro has clearly also beena crucial event for the other side of the market:companies have seen the opportunity of accessinga larger pool of investors and diversifying theirliabilities, so as to provide some competition to theirbank financiers and decrease their vulnerability tocredit crunches.

As in the public sector, bond-issuance policy in theprivate sector changed fundamentally in Europe inthe late 1990s. For example, the size of the largestissues increased substantially. While in 1998 there

were just three bond issues in euro legacy curren-cies above the equivalent of €1 billion, the threeissues by Tecnost, the financing vehicle for Olivetti’stakeover of Telecom Italia, in June and July 1999alone raised €15.65 billion. Although these issueswere widely perceived as exceptional, issue sizes ingeneral in Europe have increased significantly since1999, with issues above €1 billion becoming moreand more frequent.

Furthermore, the quality range of bond issues ex-panded significantly. In particular, the average creditrating of issuing companies has fallen significantlysince EMU. While European bond markets used tobe dominated by AAA and AA issues, almost 50 percent of all corporate bonds issued in 1999 had asingle A credit rating. Further down the spectrum,even the first signs of a European junk bond marketexist, although this segment is still underdeveloped.

Interestingly, Rajan and Zingales (2003) show thatthe boom of the corporate bond market after theintroduction of the euro was indeed stronger in theeuro area than outside. They conduct a simple paneldata analysis for a sample of European countriessince 1990 and find that net private debt issuesbecame significantly larger for countries that adoptedthe euro. This suggests that the introduction of theeuro had a causal impact on the development of thecorporate bond market in Europe.

Much of this supply-side development is undoubt-edly due to the boom of some industries, such astelecommunications, which were liberalized andderegulated in the late 1990s in many western

Table 3Bank Debt of Non-financial Firms

All non-financial firms, 1993 239 largest manufacturing firms, 1996

Benelux 83.2 48.1France 80.2 44.3Germany 85.1 63.2Italy 94.6 73.9Spain 77.3 —United Kingdom 49.4 34.1United States 32.4 9.4Japan — 56.4

Note: Numbers are shares of bank debt in total debt.Source: Danthine et al. (2001).

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European countries. The resulting restructuring andconsolidation fuelled a wave of mergers and acqui-sitions (M&A) that were largely financed by bonds.After the collapse of the equity market in 2000 andthe worsening of the commercial paper market inthe early 2000s, the bond market gained particularimportance as a source of long-term funding. Fig-ures 2(a) and 2(b) show that debt issuance wasclosely correlated with M&A activity both in theeuro area and in other European countries (chieflythe UK, which accounts for most M&A activity inthe second group). The correlation is actually greaterin the euro area (94.3 per cent) than in otherEuropean countries (66.3 per cent), but the totalvalue of M&A deals is much larger in the secondgroup of countries.

Finally, Table 4 shows that the lion’s share ofprivate-sector international debt securities in Eu-rope continues to be issued by financial institutions.8This feature was weakened in 1998–2001, when theshare of non-financial corporate issues began ex-ceeding 20 per cent, but was reasserted in 2002–3when it declined to traditional levels of 10 per centand lower. However, the current breakdown is notdissimilar to that in the USA.

(iii) The Demand Side

At the same time as the supply of euro-area bondsincreased and issuance policies converged, geo-

graphical diversification increased strongly in euro-area bond portfolios on the demand side.

This change was felt most dramatically with privateissues. While until 1998 bond distribution in the eurozone for all but the very few largest firms wasalmost exclusively domestic, the larger bond issueswere already in 1999 sold on a truly European scalethat surprised even most market participants. Atypical example was the €1 billion issue of Alcatel,the French telecom firm, in February 1999, 28 percent of which was placed with Italian and more than20 per cent with German investors. Alcatel’s sur-prised Chief Finance Officer remarked, after theissue, ‘that a French corporate can sell its bondsprimarily to Italy is something new’. A similarexample was the 1999 issue by Principal Life, a USinsurer, where the head of the syndicate at CreditSuisse First Boston for the European issue notedthat ‘we sold 30 per cent of this deal in France. Inthe past we might have sold 3 per cent there’.9

A similar evolution happened in the public bondmarket. According to European Central Bank (ECB)data quoted by Blanco (2001, Table 3), the share ofeuro-area government securities held by non-resi-dents increased steadily from 16 per cent in 1991 to26.8 per cent in 1998 and up to 33.5 per cent in 2000.As shown by Adam et al. (2002), much of thisincrease is due to institutional investors. Their studylooks at the share of assets managed by money and

8 The break-down of domestic private issues is not available for the whole 1994–2003 interval. However, from available data Europeannon-financial corporations appear more active domestically than internationally, which contradicts the finding in Table 4.

9 See Euromoney, August and September 1999.

Table 4Issuance of Private-sector International Debt Securities by Area and Type of Issuer

Area/issuer 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

United StatesFinancial institutions 19.3 32.9 84.0 98.1 138.5 182.8 230.4 191.8 302.2 246.6Corporate issuers 18.9 24.4 32.0 64.7 61.6 155.6 47.3 72.4 28.6 27.8

Euro areaFinancial institutions 68.6 87.5 154.0 147.2 163.8 356.5 430.3 325.2 385.6 591.4Corporate issuers 7.2 8.1 4.4 17.1 32 120.5 96.1 82.7 10.6 56.8

Note: Net issues in US $ billion.Source: BIS, own calculations.

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Figure 2Bond Issuance and M&A Activity in Europe

(a) Private net bond issues and (b) Private net bond issues and value of M&A deals, Euro-area value of M&A deals, other European countries

Note: M&A activity is the total value of all M&A deals whose value is reported in the SDC Platinumdatabase (US $ billion). Net bond issues are private-sector issues (US $ billion).Sources: Thomson Financial Securities Data and BIS, respectively.

bond funds that pursued a Europe-wide investmentstrategy between 1997 and 2001, based on dataprovided by the Fédération Européenne des Fonds etSociétés d’Investissement (FEFSI).10 The figures givenby Adam et al. (2002) have been recalculated andupdated to 2003 by Baele et al. (2004). Both studiesindicate that the adoption of the euro is associatedwith a large increase in the asset share of interna-tionally investing bond funds in Austria, Finland,France, and Germany, with most of the changeoccurring at the time of the introduction of the euro.The euro-area unweighted average of the share ofassets invested in bond funds with a Europe-widestrategy rose from 17 per cent in 1998 to 60 per centin 2002 (Baele et al., 2004, Chart 21).

Incidentally, a similar shift occurred also in theinvestment policies of pension funds and life-insur-ance companies, since EMU relaxed a number ofregulatory restrictions on the currency matching ofassets and liabilities, such as a 20-per-cent ceil-ing on the permissible mismatch in their denomi-nation and other restrictions on the purchase offoreign assets.

Table 5 (column 1) shows that by 2003 more thanhalf of the assets of bond funds were invested withan Europe-wide strategy in each euro-area countryexcept Spain (the latter being likely due tomisclassification of Spanish funds in the FEFSI database). The countries where bond funds are morediversified are Belgium, Italy, and Portugal. Thegreater appetite for diversification by investors basedin these countries may reflect their greater concernwith the solvency risk of their respective homeissuers: Belgium, Italy, and Portugal have the low-est-rated debt among those for which these data areavailable.11

Interestingly, this shift in portfolio-allocation strat-egy is limited to the euro area, in two senses. First,it is peculiar to bond funds based in the euro area: inDenmark, Sweden, and the UK the share of bondfunds with a European-wide investment strategyremained low and rather stable between 1998 and2001 (Adam et al., 2002). Second, euro-area fundsdid not extend their diversification strategy also tobonds issued outside the euro area itself: the shareof bond funds with a global bond investment strategy

10 However, the FEFSI classification of funds according to their investment strategy (domestic, European or global) and type(money market, bond, or equity) seems not entirely consistent across countries, being based on national schemes.

11 These figures are a lower bound on the diversification attainable by individual investors since, even if all funds in a given countrycompletely specialize in domestic investments, individual investors can diversify internationally by holding a mix of funds offeredby foreign intermediaries, if they have access to the investment products of other countries.

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actually declined from 30 per cent in 1998 to 20 percent in 1999 and stood roughly constant at that leveluntil 2003. Apparently, euro-area investors nowview the euro-area bond market as their homemarket, so that the traditional home bias ‘may havebeen replaced with a “euro area home bias”’ (Baeleet al., 2004, p. 54).

Rather than asking how diversified euro-area bondportfolios are, one can look at the weight of foreigninvestors in each of the euro-area bond markets.The latter is only to a certain extent related to theformer. For example, the investors from a givencountry can have diversified portfolios and stillabsorb most of the domestically issued bonds. Moreo-ver, foreign investors include also those based out-side the euro area.

But it turns out that along this dimension, too, theeuro-area bond market has become highly inte-grated. Euro-area public debt bought by interna-tional investors is currently 61.2 per cent of the total(unweighted average, excluding Germany), accord-ing to data collected by national treasuries andreported by MTS Group (2004). As shown in col-umn 2 of Table 5, the investor base is more interna-

tional in euro-area countries with a smaller absoluteamount of outstanding debt, such as Austria, Fin-land, Ireland, the Netherlands, and Portugal, possi-bly because foreign institutional investors loom largerin these small markets.

(iv) The Response of Intermediaries

While euro-area governments laid the institutionalframework for an integrated bond market, financialintermediaries supported this integration by provid-ing increasingly homogeneous secondary tradingfacilities and by competing on the primary marketfor government debt and corporate issues. Thisresponse by financial intermediaries was obviouslytriggered by the considerable business opportunitiesstemming from a pan-European bond market, but inturn it reinforced the process of integration, byfeeding back into the behaviour of other marketparticipants. For instance, trading platforms sethomogeneous and more demanding requirementson issuers’ policies and on dealers’ market-makingactivity, and at the same time allowed investors toaccess an increasingly large menu of bonds withstandardized trading procedures.12 Similarly, invest-ment banks’ more aggressive competition for un-

Table 5International Diversification of Bond Portfolios in the Euro Area

Country Share of assets invested in bond market funds International investor basewith Europe-wide investment strategy, as fraction of total investor base,

% in 2003 % in 2004

Austria 55 90–99Belgium 88 48.4Finland 61 62France 60 37Germany 52 —Greece — 55Ireland — 75Italy 81 42Netherlands — 81Portugal 98 80Spain 0 37Average 62 61.2

Sources: The numbers in column 1 are from Baele et al. (2004, p. 53); those in column 2 are from MTSGroup (2004, p. 13).

12 While the contribution of electronic trading platforms to euro-area bond market activity appears to be substantial, we are notaware of any formal econometric analysis that attempts to quantify such a contribution.

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derwriting business reduced and homogenized thefees they charged to corporate customers, increas-ing companies’ inducement to issue bonds even inthe low-grade segment.

Public debt trading platformsThe emergence of pan-European trading platformshas been an important force in the process ofintegrating the secondary market for Europeangovernment bonds. The most important among themare MTS in the cash market, and EUREX in thefutures market.

MTS is a quote-driven, electronic trading platformthat emerged from a public institution created in1988 by the Italian Treasury and the Bank of Italyin collaboration with Italian primary dealers, toimprove the liquidity of the Italian government bondmarket. The success of its trading model led to itsprivatization in 1997 and to the expansion in 1999into the Netherlands, Belgium, and France, estab-lishing similar trading platforms—a first set of do-mestic MTS markets.

Currently, MTS is the parent company that partiallyowns subsidiaries in all the euro-area countries andin Denmark,13 and trades government bonds inseveral eastern European countries through its divi-sion ‘New EuroMTS’ (since November 2003).MTS S.p.A. is owned by financial intermediaries: 55per cent of its capital belongs to non-Italian banks,and 45 per cent to Italian ones.

The breakthrough in MTS’s business model was thecreation of EuroMTS, a pan-European inter-dealerplatform that offered trading facilities for the largestand most liquid European government bonds andsubsequently became the standard setter for Euro-pean benchmark bonds—that is, the newly issuedbonds at the 5- and 10-year maturities. The key tothe success of this trading platform is to be found notonly in its technical capabilities but also in MTS’sability to bring together issuers and dealers and tocommit them to a few simple rules so as to foster

secondary market liquidity—a mutual commitmentthat MTS labels a ‘liquidity pact’. Dealers commit toquote continuously two-way firm prices with amaximum spread, and issuers commit to an issuelisting size at least equal to €5 billion for benchmarkbonds and to a random allocation of bonds amongbond dealers for quoting obligations. Moreover,MTS volumes contribute to the total trading volumethat Treasuries require of all dealers for admissionto the primary market. In this way, the MTS-sponsored ‘liquidity pact’ has promoted the homog-enization of the euro-area sovereign bond marketaround minimum standards of size and liquidity.14

For its part, MTS guarantees high pre-trade trans-parency, feeding real-time price and quantity data tofinal investors via 20 data distributors, and therebyencouraging competition in quotation-setting.

Table 6 illustrates the impressive liquidity of the 10-year and 5-year benchmark bonds traded onEuroMTS. The bid–ask spread statistics in the tableare based on daily data for 2002 and 2003 and referto the best bid and ask prices quoted at 11 a.m.during all business days across all the cash markets.The data show that the average bid–ask spreads aretiny, ranging between 2 basis points in the most liquidmarket (Italy) to almost 5 in the least liquid (Finland).Interestingly, the German cash market is not themost liquid one, even in the 10-year maturity bucketfor which the Bund is considered the benchmark.This is because most of the trading for 10-yearGerman bonds occurs on the futures market, whichis more liquid and far deeper than the correspondingcash one. Table 6 also shows that the bid–askspread does vary over time: for instance, for Italy itranges between a minimum of 1.2 and a maximumof 15 basis points. As we shall see, the time variationof liquidity is important in the empirical analysis ofyield differentials.

Liquidity is lower for issues that are no longerbenchmark bonds. These are traded in the domesticMTS markets, where the liquidity and size require-ments established on EuroMTS for benchmark

13 MTS created subsidiaries or divisions in the Netherlands in September 1999, Belgium in May 2000, France and Portugal inJuly 2000, Finland in April 2002, Spain in May 2002, Ireland in June 2002, Austria in June 2003, and Denmark, Greece, and Germanyin November 2003 (but has traded German bonds since April 2001 through a division of EuroMTS).

14 More recent innovations by EuroMTS include a real-time index of European government bonds (since 2003), the verticalintegration into clearing and settlement, and the expansion into the corporate bond market through its BondVision subsidiary. Atthe time of writing, it is too early to evaluate these developments.

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bonds are not enforced. However, the benchmarkrequirements tend to extend automatically also tothese bonds, as older issues are gradually replacedwith new ones, which formerly were benchmarkissues.

While the market discipline imposed by the ‘liquiditypact’ on dealers creates obvious benefits to allmarket participants, the discipline is not perfect andthe ‘pact’, like most other multilateral arrange-ments, is prone to moral hazard. The problem is thatindividual market participants can benefit from theliquidity provided by everybody else even at theexpense of others, in which case the discipline canbecome a liability for the complying market-makers.This indeed happened on 2 August 2004, whenCitigroup flooded MTS (and other trading plat-forms) with sales of almost €12 billion across morethan 200 bonds within seconds, pushing down pricesby about 15 cents. As banks tried to hedge on theBund future market, the future price dropped 47cents. At that point, Citigroup bought back €4 billionof bonds at lower prices on the MTS trading sys-tem.15 The price drop was quickly reversed, andCitigroup earned an estimated €15 million at the

expense of other market-makers.16 In effect,Citigroup was able to earn this sum because it hada fleeting informational advantage over the rest ofthe market: the information about its own futuretrading strategy, which is price-relevant because ofthe sheer size of the orders that it can place.Normally, when they suspect that they may bereceiving orders from an informed trader, market-makers protect themselves by widening their quotesor refusing to trade. But the MTS market-makerswere committed to quoting firm prices for largeamounts and keeping tight spreads, and this allowedCitigroup to trade such a large amount before theycould react.

Besides exposing the market’s vulnerability to mani-pulation by large traders, this episode may be adeliberate attempt to break the ‘liquidity pact’ by alarge market-maker. That Citigroup shows littleconcern for the liquidity of MTS may partly stemfrom its inherent conflict of interest vis-à-vis thistrading platform—a situation common to severalother large market players. It is at the same time amarket participant and dealer in all 11 MTS sover-eign bond markets, a shareholder of MTS, and a

Table 6Liquidity of the EuroMTS Market

Country 10-year benchmark bonds, 5-year benchmark bonds,daily bid–ask spread data, 2002–3 daily bid–ask spread data, 2002–3

Average Minimum Maximum Average Minimum Maximum

Austria 4.6 2.8 9.8 4.1 2.8 6.5Belgium 3.5 2.4 6.6 2.7 2.0 3.6Finland 4.9 2.8 8.4 4.1 2.8 6.2France 2.9 1.6 5.0 2.5 1.8 3.4Germany 3.2 2.0 7.0 3.2 1.8 5.0Italy 2.5 1.2 15.0 2.1 1.0 3.7Netherlands 3.5 2.6 5.6 3.7 2.4 5.0Portugal 4.3 2.7 8.4 3.2 2.2 4.6Spain 3.5 2.0 6.4 2.9 1.6 4.6Average 3.66 2.23 8.02 3.17 2.04 4.73

Note: The bid–ask spread is measured in basis points and computed as the difference between the best bid andask prices (divided by the mid-quotation) quoted at 11 a.m. during all business days in EuroMTS cash markets.Source: MTS Group.

15 This account is based on a number of news reports in August 2004 and MTS sources.16 Citigroup’s profit could have been even larger if a few dealers had not eventually stopped trading as the US bank kept buying

back bonds at lower prices, as reported by Munter and van Duyn (2004).

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potential competitor of the trading platform owing toits in-house trading capabilities and its participationin competing platforms. This episode indicates that,for all their benefits to issuers, the implicit rules thatguarantee the impressive liquidity of MTS are notunchallenged.17 Accordingly, it has raised concernsby government officials that disruptions to marketliquidity may increase the cost of issuing debt, andprompted investigations by security regulators forthe possible breach of trading rules.

While MTS is by far the largest trading platform inthe euro-area cash market (especially in the Italianmarket), it has a low profile in the German bondmarket, where trading concentrates in the deriva-tives market, especially in the futures market man-aged by EUREX. The volume of trade on EUREXincreased almost tenfold between 1996 and mid-2001, from €172.4 billion to €1,639.1 billion (seeBlanco, 2001, Table 4).18 In the process it killed offBund futures trading on London’s LIFFE. Alsofutures trading in French, Italian, and Spanish bondsdwindled into disappearance by 2001.

The trading activity in the futures based on Germanbonds is so large that the open interest of the Bundfutures contracts often exceeds the stock of deliv-erable bonds. This occasionally generates ‘squeezes’,which are situations where few market participantsbuy a large fraction of the deliverable bonds beforethe maturity of the future contract. If successful,they profit at the expense of the holders of shortpositions in the futures contract, who must borrowdeliverable bonds and lend money at below-marketrates in the repo market. Squeezes generate suddenincreases in the price of bonds, which spill over tothe corresponding cash and repo markets. Theproblem is amplified by the relative lack of depth ofthe German cash market, coupled with the fact thatother euro-area bonds are still less than perfectsubstitutes of German Bunds, as we shall see insection III.

Corporate-bond underwritersThe successful integration of secondary govern-ment bond markets in the euro zone is not paralleledin the corporate bond market, which is more frag-mented. Most of this fragmentation is due to thefragmentation of clearing and settlements systemsin Europe. Although the problem has been wellknown since the late 1990s (see, for example,Padoa-Schioppa, 1999), progress has been slow.Securities settlement in the euro area is still domi-nated by national players, whose number had onlycome down from 23 to 14 by 2003 (compared to twoin the USA), and hampered by national rules thatrestrict cross-border activities of settlement houses.19

Yet, as highlighted in section II(ii), the true explosionof bond issuance associated with EMU occurred inthe corporate-bond market, not in the sovereign-bond segment. An important reason for this successwas the corporate-bond underwriters’ response toEMU. As the barriers that segmented the Europeanmarket for corporate-bond underwriting began toerode, investment banks started to benefit from thescale economies in the provision of underwritingservices and from the lower entry barriers in theindustry. Santos and Tsatsaronis (2002) show that,as a result, underwriting fees in the euro-denomi-nated market converged rapidly with the corre-sponding fees in the dollar-denominated segment ofthe industry. They show that, while total underwriterproceeds quadrupled between 1998 and 1999 (andremained around the new level until 2001), theaverage gross fees in the euro-denominated seg-ment of the bond market halved in the year the eurowas introduced, dropping from 1.7 per cent in 1998to 0.8 per cent in 1999, and remained at the averagelevel of 0.6 per cent in the 1999–2001 period—exactly the same figure as in the US-denominatedsegment (Santos and Tsatsaronis, 2002, Table 5).By multivariate regression analysis of a sample of3,110 bonds, they highlight the key role of EMU inthe reduction of fees.

17 It should be noticed that the formal rules of MTS do not prescribe spreads as tight as those actually quoted: the actual spreadsare five times tighter than the required ones. But issuers informally require banks to quote the tightest possible spreads, and thisinduces them to take such positions with so little reward and, as this episode highlighted, so much risk.

18 Between 1999 and 2003, the number of contracts for Bund, Bobl, and Schatz traded yearly on EUREX increased by 126.6per cent; by comparison, over the same interval, the value of yearly trading volume on the MTS cash platform increased by 46.7per cent (data kindly provided by Philippe Rakotovao).

19 The report by the Giovannini Group (2003) provides an assessment of the situation and proposes various policy reactions.

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Melnik and Nissim (2004) confirm the convergenceof underwriting characteristics (extent of under-pricing, underwriter compensation, bond maturity,syndicate size) in the euro area and the USA afterEMU, but point out that the reduction of fees alonedoes not mean that EMU has reduced underwritercompensation. In a careful analysis of the pricing ofEurobond issues around 1999, they show that thestrong reduction in underwriter fees after 1998 wasalmost fully compensated for by an increase in theunderwriter spread (i.e. the difference between theprice charged to the public and the price guaranteedto the issuer). Thus total underwriter compensationremained largely stable with the introduction ofEMU. The real impact of EMU, according toMelnik and Nissim (2004), was the almost completeelimination of the significant bond underpricing thathad prevailed until 1998.

At the same time, the degree of concentration in theindustry dropped, especially as a result of the entryof US investment banks into this market: theHerfindhal index more than halved, from 971.2 in1998 to 400 in 1999, and the share of the top fivebanks dropped from 57.1 to 33.4 per cent (Santosand Tsatsaronis, 2002). The increased competitionwas felt particularly in the smaller currency seg-ments, where before EMU the share of the top 5bookrunners was higher than 75 per cent. Interest-ingly, borrowers appear to have switched awayfrom their home-currency underwriters for theireuro-denominated issues, compared to those inlegacy currencies (59.5 per cent versus 80.5 percent before EMU). Essentially, European corporateissuers moved away from their home bankers,generally towards the larger US investment houses.

III. CONVERGENCE OF YIELDS INTHE TRANSITION TO EMU

The combined effect of EMU, concomitant institu-tional changes, and private-sector responses illus-trated so far translated into a dramatic convergenceof the yields on public debt of the same maturity onthe eve of monetary unification. This is illustrated inFigure 3 with reference to the 10-year benchmarkbonds (but qualitatively similar pictures are obtainedfor other maturities).

The figure shows end-of-month yield spreads foreuro-area benchmark government bonds relative to

Germany from January 1993 to July 2004. Theconvergence of the spreads toward zero is dra-matic. Considering all initial EMU participants (andthus excluding Greece), the mean yield spread overthe German yield fell from 218 basis points in 1995to 111 in 1996, 39 in 1997, 19 in 1998, and 20 in 1999.It rebounded slightly in 2000–1, before resuming itsdownward trend.

Most of the action in these years derives from theconvergence of the non-core EMU participants:Finland, Ireland, Italy, Portugal, and Spain, and laterGreece, which joined the euro area at the beginningof 2001. The bonds issued by Austria, Belgium,France, and the Netherlands already featured lowspreads relative to German bonds since 1996. Thisis because, before EMU, the probability of depre-ciation relative to the deutschmark was consider-able in the first set of countries, but not in the second.Indeed, for the non-core EU countries the drop ofthe 10-year yield spreads is overwhelmingly due tothe elimination of this possibility, as shown by Blanco(2001). He measures this risk factor by the spreadbetween the 10-year swap rate of the currency andthe German swap rate, and finds that the foreign-exchange factor accounts for 41 of the 46 basispoints of the 1996–8 yield differential for Finland, 37out of 45 for Ireland, 132 out of 154 for Italy, and 96out of 115 for Spain. In contrast, it accounts for anegligible fraction of the differentials for Austria,Belgium, France, and the Netherlands.

The convergence associated with the transition tothe euro is confirmed also by formal indicatorsproposed by Adam et al. (2002) using panel datatechniques. The idea behind these indicators is thatmarkets are integrated if price differentials are notpersistent, i.e. if price discrepancies are rapidlyeliminated by arbitrage, and if price dispersion forthese products is small or absent. Applied to bondyields, β-convergence measures if they converge tothe same steady-state value, by regressing theirchanges on their past levels and σ-convergencemeasures bond-market integration at a point in time,by assessing if the cross-sectional dispersion ofyields decreases over time.

Adam et al. (2002) measure β-convergence ofbond yields on data from January 1995 to September2001 for euro-area countries (plus Denmark). Theyregress the changes in bond yield spreads relative toGermany on their past levels (allowing for different

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Figure 310-year Benchmark Bond Yield Spreads, January 1993 – July 2004

Note: Yield differentials are computed as the difference relative to the yield on German 10-year benchmarkbonds, based on monthly data (end-of-month observations).Source: Datastream.

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Austria BelgiumFinland FranceGreece IrelandItaly NetherlandsPortugal Spain

coefficients in the pre- and post-EMU regimes),controlling for fixed-country effects and laggedinterest-rate changes. The coefficients of the laggedinterest-rate level—if negative—measure the speedof convergence before and after the transition to thesingle currency. The estimated coefficients arerespectively –0.041 and –0.079, both significantlydifferent from zero, though not significantly differ-ent from each other. So β-convergence appears tobe consistent with the data for the whole interval.

However, measuring σ-convergence can be ofindependent value to assess financial integration,since β-convergence does not necessarily imply σ-convergence: mean reversion does not require thecross-sectional variance to decrease, and it couldeven be associated with σ-divergence.20 Adam etal. (2002) report that in the 10-year governmentbond market the standard deviation of yield differ-entials relative to the German yield in 1999 declinedto ¼ of its 1995 value. They also regress the cross-sectional standard deviation on a broken linear timetrend, the breakpoint being January 1999. In theregression for euro-area countries only, the esti-

mated coefficients of the two time trends indicatethat σ-convergence took place until the launch ofthe euro, but not afterwards: only the coefficient thatapplies to the pre-EMU interval is negative andstatistically different from zero. This evidence addsan important element relative to that on β-conver-gence: the convergence in the euro-area govern-ment-bond market occurred before 1999, not later.This already points to the persistence of residualsegmentation under EMU—consistent with theevidence that will be reviewed in the next section.

Baele et al. (2004) propose yet another method ofmeasuring the changing degree of bond-marketintegration, based on the idea that in an integratedmarket local yields changes are driven by commonrather than local shocks. To measure the relativerole of these shocks, they estimate a regression ofthe changes in each country’s 10-year government-bond yield on a constant and the change in theGerman yield. They estimate the regression over amoving window of 18 months, so as to obtain a time-series of constant and slope estimates for eachcountry, and find that the slope coefficients start to

20 See Quah (1993) for further details on this issue.

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converge towards one after 1998. So local bondmarkets have become less affected by idiosyncraticlocal news. Accordingly, the fraction of the totalvariance in local yield changes explained by changesin the German yield increased from less than 50 percent to over 97 per cent between 1997 and 2002 inFinland, Greece, Italy, Portugal, and Spain.

The same authors also analyse the degree of inte-gration of the corporate-bond market under EMU.They wish to estimate if corporate yields embodycountry effects, after controlling for all the othermeasurable characteristics associated with the time-profile of the bond’s cash flow, with the likelihood ofdefault, and with liquidity. To this purpose, theycollect the yields of 1,256 corporate bonds fromAustria, France, Germany, Ireland, the Nether-lands, and Spain for the EMU period, and estimatecross-sectional regressions of yield differentials(relative to an equally weighted corporate-bondportfolio) on a constant and a set of bond character-istics: coupon, liquidity, time to maturity, rating,sector, and country. The estimation produces a timeseries of coefficients for each explanatory variable.Among these, the country dummies’ coefficientsmay be seen as a measure of the respective coun-try-specific risk factors. For all countries exceptGermany, these country coefficients are signifi-cantly different from zero at the 5 per cent level, butare extremely small: 4, 6, and 2 basis points forSpanish, Irish, and Austrian bonds, –8 basis pointsfor French ones, and close to zero for German andDutch bonds. They typically account for no more of2 per cent of the cross-sectional variance of yielddifferentials. This suggests that the corporate-bondmarket has also achieved a remarkable degree ofintegration.21

This study of the corporate-bond market is a usefulreminder that bond-market integration does notrequire complete convergence of bond yields. Evenin an integrated market, differentials may persist tothe extent that they are a reflection of the variousbonds’ different risk, maturity, or cash-flow charac-teristics, rather than stemming from trading costs,taxes, clearing and settlement costs, or other institu-tional barriers to trade. Due to their highly standard-

ized nature and low idiosyncratic risk, governmentbonds are well suited to an assessment of suchdifferentials. This is the objective of the followingsection.

IV. BOND-YIELD DIFFERENTIALSUNDER EMU

Despite the dramatic convergence documented inthe previous section, yield differentials have notdisappeared completely under EMU, so that euro-area sovereign bonds are still not perfect substi-tutes. This can be seen in Figure 4, which is basedon the same data as Figure 3 except for the timeinterval, which includes only the EMU period, andfor the omission of Greece, whose yield differentialwould dwarf all the others. Table 7 reports descrip-tive statistics by country and by year based on thesame data. Taken together, Figure 4 and Table 7shows four important facts.

First, yield differentials vary considerably acrosscountries, from 8 basis points for Irish debt to 26basis points for Italian one. This raises the questionof what explains these cross-country differences.

Second, for each given country the yield differentialvaries considerably over time. Therefore, yieldspreads are a source of additional risk that must betaken into account and priced by investors andtraders. This is especially important for traders whogo long in the cash market on higher-yield bondswhile hedging their interest-rate exposure by shortingthe very liquid German Bund on the future market:these positions are risky, since they are exposed toyield-spread risk. In fact, there are traded deriva-tives, such as spread options, that explicitly refer toobserved yield spreads.

Third, the yield spreads have a clear tendency to co-move. This is evident from Figure 4, but it is formallyconfirmed by the statistical evidence reported inCodogno et al. (2003), and Geyer et al. (2004). Thiscomovement implies that yield-spread risk cannotbe fully hedged by holding a diversified portfolio ofeuro-area bonds, and raises the question of what

21 An interesting attempt to estimate the determinants of yield spreads of individual corporate issues in the euro zone is Driessen(2002), who uses a three-factor model for corporate bonds of various rating classes and distinguishes between global factors, rating-class-specific factors, and issuer-specific factors.

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Figure 410-year Benchmark Bond Yield Spreads under EMU

Note: Yield differentials are computed as the difference relative to the yield on German 10-year benchmarkbonds, based on monthly data (end-of-month observations).Source: Datastream.

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Austria BelgiumFinland FranceIreland ItalyNetherlands PortugalSpain

Table 710-year Benchmark Bond Yield Differentials under EMU

(descriptive statistics by country and by year)

Time-series statistics by country Average Standard deviation Minimum Maximum

Austria 16.2 11.1 –4.1 33.8Belgium 19.8 12.3 –0.6 40.9Finland 11.9 11.0 –11.1 28.8France 10.5 6.8 –1.9 23.9Ireland 7.7 10.0 –17.1 21.4Italy 26.0 10.6 6.5 43.1Netherlands 9.4 6.7 –4.4 20.4Portugal 22.7 12.0 –1.0 43.3Spain 16.2 12.9 –9.5 35.2

Cross-country statistics by year Average Standard deviation Minimum Maximum

1999 20.0 7.0 6.7 29.42000 24.4 8.3 11.5 34.92001 26.8 9.0 11.0 37.82002 15.3 6.0 5.3 25.22003 5.3 6.1 –4.9 16.52004 (January–July) 3.0 7.0 –10.3 14.5

Note: Yield differentials are computed as the difference relative to the yield on German 10-year benchmarkbonds. The statistics are based on monthly data (end-of-month observations). The standard deviation,minimum, and maximum by year shown in the lower panel of the table are the yearly averages of therespective monthly cross-sectional statistics.Source: Datastream.

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generates such comovement. As we shall see laterin this section, the empirical studies just quoted havemade considerable progress in this direction

Finally, in the figure there is a distinct trend reductionin yield differentials relative to the Bund. One maybe tempted to conclude that convergence has con-tinued also after the inception of EMU, so that euro-area yield differentials will soon be a thing of thepast. This would be a mistake, however. The levelof most yield differentials features a trend declinebecause the yield on the Bund has been risingrelative to most other euro-area public debt, possiblyin connection with the deteriorating position of theGerman budget. But in absolute value the yielddifferentials are not declining or disappearing. Tosee that, it is sufficient to consider that their cross-sectional dispersion has remained rather stablearound a value of 7 in the period 1999–2004, asshown by the lower panel of Table 7. Also, thedifference between the maximum and the minimumhas not changed much (about 25 basis points) overthis time period, even while both the minimum andthe maximum declined gradually.

Therefore, since yield differentials cannot be yetwritten off in the euro-area government-bond mar-ket, we now analyse the determinants behind theirvariation across countries and over time, and reviewthe available evidence.

(i) Possible Determinants

The reasons why yield spreads may continue to benon-zero under EMU fall into two groups: (funda-mental) risk factors and residual market frictions.

As already noticed in our discussion of the corporatebond market, yield spreads owing to risk differencesare not inconsistent with market integration. Theymay arise from either (i) intrinsic differences incountry-specific default risk (due, for instance, todifferent debt–GDP ratios of different countries) or(ii) different sensitivities of the bonds’ future pay-offs to common shocks. As an example of the latter,consider the scenario in which EMU eventuallycollapses and euro-area countries revert to nationalcurrencies. In such a scenario, the convergenceprocess analysed in the previous section would mostlikely operate in reverse, with countries such asItaly, Greece, Portugal, and Finland experiencing

large increases in yield differentials owing to theresurgence of their currency risk. In this scenario,the holders of these bonds would suffer larger lossesthan those of other sovereign bonds. Ex ante, arevision of the estimated probability of a futureEMU collapse (a common shock) has greater ef-fects for the prices of these euro-area bonds, whichshould therefore be considered as riskier.

The other possible explanation for the persistence ofeuro-area yield differentials—market frictions—isinstead synonymous with segmentation. Frictionsinclude (i) trading costs, arising from bid–ask spreads,brokerage commissions, or transaction fees; (ii)clearing and settlement fees; and (iii) taxes. Fromthe perspective of market participants, some tradingcosts (such as the cost of market presence, clearingand settlement fees, and taxes) are exogenous,while other trading costs (such as search costs andbid–ask spreads) are endogenous in the sense thatthey result from strategic responses by marketparticipants to the structure of the market and theinformation available. Practitioners generally referto all these factors related to the ease and cost oftrading under the common label of ‘liquidity’, and, infact, often argue that the residual euro-area yielddifferentials are due to differential liquidity.

Interestingly, illiquidity can itself generate a particu-lar type of risk—liquidity risk. One may have toliquidate an asset at an unexpected time of need orbuy at an unexpected time of affluence. Risk-neutral investors would value a euro of transactioncosts identically in all contingencies. Instead, a risk-averse investor would value it differently in differentstates of the world, since his or her marginal utilityof wealth differs across different states of nature. Inthis sense, transaction costs not only have a welfarecost for investors in terms of their income effect (asthey reduce lifetime resources), but also because oftheir risk-bearing implications. If the size of thetransaction cost can vary, this creates a furthersource of risk.

In addition, fundamental risk and liquidity may inter-act with each other in non-trivial manners, which arepotentially quite important for empirical work, as weshall see in section IV(ii). Favero et al. (2004) makethis point in the context of a general equilibriummodel where idiosyncratic liquidity shocks mayforce investors to sell their bonds before maturity.

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They show that the interaction between liquidity andfundamental risk has different effects on yieldsdepending on whether one refers to current or tofuture liquidity.

If a bond has high current transaction costs, thissoftens the negative price impact of an increase infundamental risk. Here the intuition is similar to thelogic of trading distortions resulting from taxation inpublic economics. Suppose that, on an asset, thebuyer and seller must pay a proportional transactiontax. Then the larger is the transaction tax, the lowerthe after-tax price faced by either one. If the assetbecomes riskier, the effect on the price will besmaller the larger is the tax, since the initial after-taxprice is correspondingly lower. The tax effectivelyreduces the variance of the price arising from newsabout the future.

The opposite is the case if a bond is expected to havea high future transaction cost, that is, when the bondmay have to be liquidated. In this case, illiquiditytends to amplify the price effect of an increase inrisk. To understand why, consider that an asset withrisky fundamentals is one whose future cash flow is

likely to be low in ‘bad times’. If such an asset is alsorelatively illiquid, the investor who sells it in ‘badtimes’ not only is likely to get a low price because ofpoor fundamentals, but will also pay a high transac-tion cost. So liquidity risk exacerbates the effects offundamental risk. By the same token, future liquiditymay compensate for fundamental risk: when theprice of risk increases—for instance because of anincrease in aggregate fundamental risk—investorsmay prefer a more liquid bond, even if it is moresensitive to fundamental risk.

All this suggests that, to identify at the empiricallevel the factors that explain euro-area yield spreads,one has not only to account for differences infundamental risk, and for differences in liquidity, butalso for their interactions.

(ii) The Evidence

Figure 5 shows that fundamental risk clearly playsa role in euro-area yield spreads. It plots average 10-year bond-yield differentials relative to the Germanyield against the respective Standard & Poors (S&P)long-term ratings, which presumably are a summary

Figure 510-year Average Yield Differentials and Credit Risk

Note: Yield differentials are averages of the difference relative to the yield on German 10-year benchmarkbonds, based on monthly data from January 2001 to July 2004.Sources: Yields are from Datastream; S&P long-term ratings are from MTS Group (2004, p. 11).

Austria

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measure of credit risk. The points are clearly scat-tered along a regression line with positive slope, withGreece, Italy, and Portugal at the top of the range,Spain and Portugal in the middle, and Austria,Finland, France, Ireland, and the Netherlands, allwith AAA rating, closely clustered in a range from5.5 to 12.7 basis points.

Despite the paucity of the data points, this suggeststhat credit risk can, indeed, explain a considerableportion of cross-country differences in yields. Thisalready is striking, as a sovereign default of any ofthese countries within 10 years seems far-fetched,given their economic history since the Second WorldWar.22 But ratings may also reflect the differentcurrency risk of these bonds in the event of acollapse of the EMU and a re-introduction of na-tional currencies.

Even though they are closely correlated with thecross-country variation in yield spreads, ratingsexplain very little of their variation over time, whichcreates ‘yield-spread risk’. Explaining this timevariation is quite challenging, mainly because its twopossible determinants—liquidity and fundamentalrisk—are detectable on very different time scales.Liquidity is best captured in relatively high-fre-quency data, where a precise measurement oftransaction costs is possible. Fundamental risk de-termined by macroeconomic variables, instead, isbetter measured at lower frequencies, or by evalu-ating the impact of macroeconomic news over along time-horizon.23 Existing studies place them-selves at different points in this difficult trade-off toidentify the two potential determinants of yieldspreads.

Geyer et al. (2004) estimate a multi-issuer state-space version of the Cox–Ingersoll–Roll (1985)model of the evolution of bond-yield spreads (overGermany) for four EMU countries (Austria, Bel-gium, Italy, and Spain). They work with weekly yieldspreads for the full maturity spectrum of 2–10 years

from January 1999 to May 2002. Their approachallows the factors driving the process of yieldspreads to be left unspecified and the number andtype of relevant factors to be identified. Their mainfindings are that (i) one single (‘global’) factorexplains a large part of the movement of all fourprocesses, (ii) idiosyncratic country factors havealmost no explanatory power, and (iii) the variationin the single global factor can to a limited extent beexplained by EMU corporate-bond risk (as meas-ured by the spread of EMU corporate bonds overthe Bund yield), but by nothing else (in particular notby measures of liquidity), and thus remains largelymysterious.24

The most striking finding by Geyer et al. (2004) isthe virtual absence of country-specific yield-spreadrisk. In fact, when they estimate a version of theirmodel restricted to one common factor and onecountry-specific factor for each country, the fourcountry-specific factors still have an average corre-lation of 0.76, almost as high as the correlationamong common factors in individual-country mod-els. Therefore, they focus on a model with twocommon factors for all issuers and no country-specific factors. In this estimation, all country-specific factor weights are highly significant andstandard errors of residuals small. They concludethat ‘there is no . . . issuer specific structure in EMUgovernment bond spreads’ and that ‘country-spe-cific variation in spreads is best modeled by country-specific Gaussian errors’ (p. 188).

Therefore, it is no surprise that these authors find norole for their liquidity variables, which are typicallyrelated to local market features and frictions. Theirmeasurement of liquidity variables is, however, notvery satisfactory, as they do not use data on bid–askspreads, which are commonly considered to be thebest measures of liquidity,25 but rather indirectmeasures of liquidity, such as the yield differentialbetween on-the-run and off-the-run bonds and theissue size.

22 The relevance of sovereign default risk is further supported by credit default swap (CDS) data, available for most EMU countriessince 2001. As documented by Codogno et al. (2003) for 2002, CDSs were priced between close to zero basis points (for France)to more than 12 basis points (for Italy) relative to Germany, suggesting that markets perceived and priced the possibility of a defaultfor at least some euro-zone countries (this evidence should not be overstated, as the market for CDSs is fairly thin and market prices,therefore, are noisy).

23 For such analyses using US data see Balduzzi et al. (2001) and Green (2004).24 The same applies to the result by Collin-Dufresne et al. (2001), who analyse US corporate-bond spreads.25 See, for example, Fleming (2001).

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The studies by Codogno et al. (2003) and Favero etal. (2004) address this problem, by using richer datato measure liquidity, including data on bid–askspreads in the EMU government bond market.Furthermore, these studies are more explicit in thesearch for relevant risk factors, by including specificinternational and domestic factors in their regres-sions.

Using monthly data, Codogno et al. (2003) proxy thecountry-specific risk factor by national debt to GDPratios (noting that other variables do not add ex-planatory power) and international risk factors byUS bond-yield spreads.26 Similarly to Geyer et al.(2004), they find that the domestic risk factor isirrelevant, except for the cases of Austria, Italy, andSpain. Interestingly, for the last two countries theratio of debt to GDP is insignificant as a singlevariable, but significant when interacted with one ofthe US risk factors. This non-linearity points to apossible interaction between international marketconditions and domestic fundamental risk. In par-ticular, it suggests that, at least for Italy and Spain,international investors take domestic risk into ac-count when reacting to changing world market risk(as proxied by US market conditions).

In a second approach, Codogno et al. (2003) com-bine the daily data on US bond prices with daily dataon bid–ask spreads and market activity for Euro-pean government bonds in 2002. With daily data, ofcourse, macroeconomic variables move too slowlyto allow estimation of the impact of the domestic riskfactor, and thus are not included. In this estimation,the international factor is statistically significantlydifferent from zero for all countries except forFinland, France, and Ireland, while liquidity (asmeasured by the trading volume on EuroMTS) playsa statistically significant and correctly signed rolefor France, Greece, the Netherlands, and Spain.When compared to the first set of results in the samepaper, the fact that international risk remains signifi-cant for several countries, once liquidity is controlledfor, may imply that ‘differences in default risk arethe main propagation mechanism’ (p. 524). But, asthe authors admit, this conclusion is not very strong.

In particular, most countries in the sample displayvery similar debt to GDP ratios, with only Belgiumand Italy clearly above, and Ireland clearly belowthe median. Hence, it seems difficult to attributeobserved market segmentation directly to thesenational differences.

Favero et al. (2004) analyse the possible causes andconsequences of liquidity in more detail. In particu-lar, they point out that transactions costs shouldaffect yield differentials in two ways: directly witha positive sign (as investors require higher returns tocompensate them for transaction costs), and indi-rectly through the interaction of liquidity with funda-mental risk. The sign of the coefficient of thisinteraction term depends on whether the liquidityvariable reflects current or future trading costs, asexplained in section IV(i) above. Depending onwhich component is more prominent, the impact ofchanging international (common) risk factors maybe different. The main insight of the theory for theeconometric specification is that liquidity effectsshould enter both linearly and via their interactionwith the risk factor.

The empirical analysis by Favero et al. (2004) uses2 years of daily transactions data from EuroMTSand bid–ask spreads carefully synchronized withreturn data. First, they confirm the previous twostudies’ finding that the international risk factor ishighly significant for all countries.27 Second, theyfind a greater role for liquidity variables, providedthey are interacted with risk variables in the speci-fication, as suggested by their model. Focusing forbrevity on their results for the 10-year maturity, thecoefficient of the bid–ask spread is positive for allcountries except Finland, but significantly differentfrom zero only for Austria, Belgium, the Nether-lands, and Portugal. So, as predicted by the theory,for these four countries a higher bid–ask spread isassociated with a higher yield spread. Importantly,in all four cases, the positive effect of the bid–askspread on yield differentials is paired with a signifi-cantly negative coefficient of the interaction termbetween the liquidity measure and the interna-tional risk factor. This illustrates the importance of

26 More precisely, the two variables considered are (i) the spread between fixed interest rates on US swaps and US government-bond yields and (ii) the spread between the yields on US AAA corporate bonds and government bonds (all for 10 years). The variablesproxy the risk of the banking and the corporate sectors, respectively.

27 In this study, the international risk factor is measured as the spread between the fixed interest rates on US swaps and the yieldon US government bonds of the same maturity.

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non-linearities in the effect of liquidity indicators onyield differentials. In fact, the coefficient of theliquidity differential is significant only when thisinteraction term is included.

In conclusion, despite their considerable differencesin the methodology and data used, all three studiesagree on the finding that yield differentials underEMU are driven mainly by a common risk (default)factor, related to the spread of corporate debt overgovernment debt. They also agree on the conclusionthat liquidity differences have at best a minor directrole in the time-series behaviour of yield spreads,and—according to the last of the three studies—anindirect role, in that they modify the impact of therisk factor on yield spreads.

An open question remains about why the commoninternational risk factor is best measured by thedifferential between corporate- and public-bondyields in Europe and in the USA: does this captureevents in the USA that have a direct impact onEuropean bond markets? Or is there a commonlatent variable that makes European and US datacomove? And if there is such a common factor, is itsimpact on European spreads mainly a direct one oris it mediated by liquidity or macroeconomic vari-ables?

A possible approach towards answering the firsttwo questions is to study the dynamic linkagesbetween the time series of bond returns explicitly.This is done by Skintzi and Refenes (2004) whoestimate an extended GARCH model of Europeanand US weekly bond returns and (time-varying)volatilities.28 They find stronger evidence forspillovers between the volatilities of the return seriesthan for the returns themselves. In particular, theyfind return spillovers from a euro-area index into theseries of four out of eight EMU countries (Belgium,France, the Netherlands, and Spain), and volatilityspillovers for six out of the eight countries (Austria,Belgium, France, Germany, Italy, and Spain). Thesespillovers have intensified after the start of EMU.For the four European non-EMU countries in thesample, they find no spillovers for returns, butvolatility spillovers into the series for Denmark,Sweden, and the UK.

Concerning the impact of the US series (modelledas an exogenous factor), Skintzi and Refenes (2004)find an impact on returns within EMU only forAustria, Belgium, and Spain (and the threeScandinavian countries), but a clear impact on thevolatilities of all eight EMU countries. The first ofthese two results is surprising in the light of thefindings discussed earlier in this section, and thesecond suggests that further studies should paymore attention to volatilities, and not only returns.

V. CONCLUSIONS

The years since monetary unification have wit-nessed the emergence of an integrated euro-areabond market. Issuers and investors alike have cometo regard the euro-area bond market as a single one.Primary and secondary bond markets have becomeincreasingly integrated on a pan-European scale.Issuance of corporate bonds has taken off on anunprecedented scale in continental Europe. In theprocess, both investors and issuers have reaped theconsiderable benefits afforded by greater competi-tion in the underwriting of private bonds and in theauctioning of public ones, and by the greater breadthand liquidity of secondary markets.

These benefits have been particularly valuable foreuro-area governments, many of whom must serv-ice a large stock of public debt: for them, evenshaving a few basis points off the cost of debtservicing makes a considerable difference in termsof reduced taxes to be raised in the future. But thebenefits have been no less important for Europeancompanies, which have acquired cheaper access toa market that can disenfranchise them from banksfor the provision of debt finance. The effect oncompany financing and the attendant effects oncredit markets are likely to be the most pervasivelegacy of European bond-market integration.

Bond yields have converged dramatically in thetransition to EMU. The persistence of small andvariable yield differentials for sovereign debtunder EMU indicates that euro-area bonds are stillnot perfect substitutes. However, to a large extentthis is not the reflection of persistent market

28 The EMU countries in their study are Austria, Belgium, France, Germany, Ireland, Italy, the Netherlands, and Spain; theEuropean non-EMU countries Denmark, Norway, Sweden, and the UK. They rely on the national Datastream Benchmark BondIndices (total returns) with 5 years average maturity for the period 1 February 1991 to 31 December 2002.

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segmentation but of small differentials in fundamen-tal risk—either in default risk or in vulnerability tothe risk of eventual EMU collapse. Liquidity differ-ences appear to play at most a minor direct role, buta more significant role through their interaction withchanges in fundamental risk.

The challenges and opportunities still lying aheadare numerous. First, there is a striking unbalancebetween futures and cash markets. Euro-area fu-tures refer almost entirely to German bonds, whilethe cash market for German bonds is far lessdeveloped, which periodically determines squeezesand inefficient price volatility. In contrast, otherlarge cash markets, such as the Italian one, are veryliquid but lack a corresponding future market.

Second, the impressive liquidity of the cash marketsis due to market-makers’ collective commitment toquote bid and ask prices for very large amounts atvery tight spreads; but this commitment is vulner-able to free-riding and manipulation by large finan-cial institutions, as the August 2004 Citigroup epi-sode demonstrates. It is still unclear whether suchopportunistic behaviour is a serious threat to thepersistence of the current liquidity levels.

Third, the possibility of joint bond issuance by euro-area countries has been repeatedly considered be-cause of its ability to exploit fully the liquiditybenefits of a completely unified market. However,issuers have so far discarded it because it wouldgenerate an implicit debt guarantee by some coun-tries in favour of others, with potentially seriousincentive effects on fiscal discipline. The challengehere is to design a scheme capable of reaping theliquidity benefits of joint issuance, while minimizingits adverse effects. For instance, joint issuancecould be allowed only to EU countries that respectcertain standards of fiscal discipline and/or could belimited to short maturity bonds.

Another challenge is to overcome the persistentfragmentation of clearing and settlement systems inthe euro-area bond market, which prevents a fullintegration of the market for private-sector bonds.

Last, but not least, the euro-area bond market willexpand further as new EU member countries gradu-ally join EMU. In fact, in anticipation of this out-come, their bonds are already being actively tradedon the same platforms that cater to the bonds ofexisting EMU members.

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The European Bond Markets under EMU

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