Euro area sovereign bond risk premia before and during the Covid-19 pandemic.

We provide a novel modeling framework to decompose euro area sovereign bond yields into five distinct components: ( i ) expected future short-term risk-free rates and a term premium, ( i i ) a default risk premium, ( i i i ) redenomination risk premium, ( i v ) liquidity risk premium, and ( v ) segmentation (convenience) premium. Identification is achieved by considering sovereign yields jointly with other rates, including sovereign credit default swap spreads with and without redenomination as a credit event trigger. We illustrate our model by studying yield components embedded in German, French, Italian, and Spanish sovereign bonds, before and after the onset of the Covid-19 pandemic in 2020, and by examining the impact of European Central Bank (ECB) monetary policy and European Union (EU) fiscal policy announcements in response to the pandemic. We find that all five risk premia became sizable following the onset of the pandemic, and that both monetary and fiscal policy announcements had a pronounced effect on yields, mostly through default, redenomination, and segmentation (convenience) premia.

Can EU Bonds Serve as Euro-Denominated Safe Assets?

A safe asset is of high credit quality, retains its value in difficult times, and is traded in liquid markets. We show that bonds issued by the European Union (EU) are widely considered to be of high credit quality, and that their yield spread over German Bunds remained contained during the 2020 COVID-19 pandemic recession. Recent issuances and taps under the EU's SURE and NGEU initiatives helped improve EU bonds' market liquidity from previously low levels, while also reducing liquidity risk premia. Eurosystem purchases and holdings of EU bonds did not impair market liquidity. Currently, an obstacle to EU bonds achieving a genuine euro-denominated safe asset status, approaching that of Bunds, lies in the one-off, time-limited nature of the EU's COVID-19-related policy responses.