Sovereign Yield Curves as an Indicator of Financial Stress

Sovereign Yield Curves as an Indicator of Financial Stress

The slope of an issuer’s yield curve contains information about the issuer’s perceived credit quality. The yield curve of Greece remains inverted, while those of Ireland, Italy and Spain are currently upward sloping. Portugal’s is still inverted, but the degree of inversion has been declining lately.

How much risk is there in European sovereigns? One way to answer the question is to look at yield spreads of different countries’ bonds and compare them to those of other countries, or of other fixed income classes. During 2011, for example, the yield spread on an index of European sovereign debt became comparable to that on an index of US investment-grade corporate issues (Figure 1). But information can be derived not just from the magnitude of yield spreads but also from the shape — in particular, the slope — of issuers’ yield curves. As we discuss below, changes in the slope of sovereign yield curves provide valuable information on the credit market’s views on the ability of policy responses to resolve the European sovereign debt crisis.

Near-term vs. long-term default risks
The shape of an issuer’s yield curve often varies with its underlying credit quality and with market conditions. Issuers of relatively high credit quality, whether corporate or sovereign, tend to have upward sloping yield curves, because investment risk tends to grow with longer horizons. High yield issuers, whose ability to refinance upcoming debt maturities is less certain, often trade with downward-sloping, or inverted, yield curves. Such inverted yield curves mean that investors are more concerned about such near-term risks than about the companies’ abilities to survive over the longer term.
During times of financial stress, refinancing risks can cause yield curves to invert for higher-quality issuers as well. In December 2008, for example, many companies’ yield curves were downward sloping regardless of issuer credit quality, as measured by credit ratings.

This so-called “crisis-at-maturity” explanation, which focuses on debt-refinancing risk to account for inverted yield curves, has a long history in the academic literature. 2 It is usually referred to within the context of corporate debt, but it can be applied to sovereign obligations as well.3 To be sure, there is some empirical disagreement as to the validity of the underlying theory, with some researchers finding that even lower-quality corporate issuers typically have an upward-sloping yield curve once yields of different maturities are compared for individual issuers instead of for aggregated rating categories.

Lessons from European sovereign yield curves
Nevertheless, during the past two years yield curves for sovereign issuers have contained useful information about their perceived credit quality. Figure 2 shows the yield curve for Greek government debt, proxied by the difference between its 10- and 2-year yields. Although the European sovereign debt crisis began in Greece in late 2009, the yield curve for Greek government debt remained mildly positive through the first quarter of 2010. In late April 2010, however, it began to turn negative, setting the scene for the first rescue agreement with the EU and IMF that was announced in early May. At that point, the slope turned positive again, until the beginning of 2011, when it began a gradual inversion that worsened ominously over time. The early 2011 inversion predated the next peak of the Greek crisis, in July 2011, by a good six months. The inversion lessened following policymakers’ announcement at the time of new measures intended to address the sovereign debt crisis. However, as can be seen in Figure 2, the lessening was only temporary, underlining the market’s view that the “rescue” package did not sufficiently address the underlying issues — as subsequent events seem to have demonstrated.

The yield curves of Portugal and Ireland showed that the market viewed their financial situations as less dire than Greece’s. The two countries’ yield curves remained positively sloped through 2010, although they, too, show a flattening in April 2010 in the time leading up to the first Greek rescue agreement (Figure 3). That agreement had the effect of steepening the yield curves of both Portugal and Ireland to pre-April levels. Clearly, investors anticipated that if Portugal and Ireland would need assistance, it would be provided. This proved to be the correct call, with rescue packages being put in place for Ireland in November 2010 and for Portugal in April 2011.

However, the Portuguese and Irish yield curves were unable to withstand the gravitational pull of the crisis, which remains centered on Greece. The yield curves for both countries inverted sharply in July 2011, along with Greece’s, while steepening quickly after that month’s rescue agreement. Ireland’s yield curve then remained approximately flat while Portugal’s became inverted again before steepening in late 2011 in anticipation of yet another round of policy measures.

Italy and Spain are different, as are the top-rated countries
Among the GIIPS countries,5
Italy and Spain — in contrast to Greece, Portugal, and Ireland — have not received assistance from either the EU or IMF. The yield curves for Italy and Spain have for the most part remained positive, except for Italy briefly in late November 2011 (Figure 3). Italy’s rising bond yields at the time arguably helped focus policymakers’ attention on the need for new rescue measures.

Italy’s yield curve reacted in an interesting way to the December announcement of the ECB’s provision of cheap three-year funding to European banks. It indeed steepened (Figure 4), but in effect pivoted around the four-year point. This suggests that credit investors’ concerns around refinancing risk over the next few years have been assuaged, while their longer-term worries remain intact.

Finally, yield curve slopes for Aaa-rated countries such as Germany, France, and the United Kingdom, have been consistently positive throughout the crisis (Figure 5).
Today, the yield curve slope of Greece remains negative, while the curves of Ireland, Italy and Spain are upward sloping. Portugal’s is still inverted, but the degree of inversion has been improving lately (Figure 2).
Most improvements in the shape of yield curves have come following announcements of policymakers’ actions. This underscores the usefulness of observing changes in sovereign yield curves, because they reflect the credit market’s perception of the efficacy of policy measures to resolve the ongoing European sovereign debt crisis.