Time‐varying Integration in European Government Bond Markets

• Author: Marta Gómez‐Puig,Pilar Abad,Helena Chuliá
• Published date: 01 March 2014
• Date: 01 March 2014
• DOI: http://doi.org/10.1111/j.1468-036X.2011.00633.x

European Financial Management, Vol. 20, No. 2, 2014, 270–290

doi: 10.1111/j.1468-036X.2011.00633.x

Time-varying Integration in European

Government Bond Markets

Pilar Abad

Economic Analysis Department, University Rey Juan Carlos and RFA-IREA, Madrid, 28032, Spain

E-mail: pilar.abad@urjc.es

Helena Chuli´

a

Department of Econometrics, University of Barcelona and RFA-IREA, Barcelona, 08034, Spain

E-mail: hchulia@ub.edu

Marta G´

omez-Puig

Department of Economic Theory, University of Barcelona and RFA-IREA, Barcelona, 08034, Spain

E-mail: marta.gomezpuig@ub.edu

Abstract

Bond market integration clearly changes in response to economic and financial

conditions, since the level of risk aversion changes and investors require time-

varying compensation for accepting a risky payoff from financial assets. In

this paper we examine the dynamic behaviour of European Government bond

market integration using an asset pricing model based on that of Bekaert

and Harvey (1995). Our sample period begins in 2004, after a period of calm

and tranquillity, and ends in 2009, with a significant widening of sovereign bond

spreads. Our results show evidence of time-varying level of integration for all

European countries and suggest that, from the beginning of the f inancial market

tensions in August 2007, markets moved towards higher segmentation, and the

differentiation of country risk factors increased substantially across countries.

However, the impact of the financial and economic crisis has been much more

harmful for EMU members’ sovereign bond markets, since it has prompted an

important backward step in their integration process.

Keywords: Monetary Union, sovereign securities markets, bond market integration

JEL classification: E44, F36, G15

The authors thank the editor, an anonymous referee, and participants at the XII Conference

on International Economics, the 2011 EFMA Annual Meetings and the 26th Congress of

the European Economic Association for helpful comments and suggestions. All errors and

omissions are our own. Pilar Abad and Helena Chuli´

a acknowledge financial support from

Fundaci´

on Ramon Areces. This paper is based upon work supported by the Government of

Spain and FEDER under grants number ECO2010-21787-C03-01, ECO2008-02752/ECON

and ECO2009-14457-C04-04. A version of this paper has been previously published as a

working paper n◦611/2011 in the Working Paper Series of Fundaci ´

on de las Cajas de Ahorros

(FUNCAS).

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2011 Blackwell Publishing Ltd

Time-varying Integration in European Government Bond Markets 271

1. Introduction

Since the introduction of the single currency, euro area monetary policy authorities have

had a keen interest in the integration and efficient functioning of the financial system

in Europe, especially in European and Monetary Union (EMU) countries.1Indeed,

financial integration is of key importance for the application of the single monetary

policy and for financial stability, and improves access to financial markets. However, it

is worth noting that a high degree of financial integration may decrease the opportunity

for risk diversification and raise the likelihood of spillover effects and contagion, as the

sovereign debt crisis in the eurozone has revealed.

In this paper, wewill continue the analysis presented in Abad et al. (2010, ACGP 2010

hereafter) and focus our attention on bond market integration in the European Union

(EU). The main objective of our previous paper was to study whether the introduction

of the euro had had an impact on the degree of integration of EU-15 government bond

markets. Since the extent to which integration has progressed in the EU bond market can

be assessed by measuring the relative importance of country components versus other

factors in explaining bond returns, we applied a CAPM based model and separated each

individual country’s government bond return into two effects: a local (own country),

and a systemic effect (either a regional/eurozone or a global/world effect). It is intuitive

that as integration advances, the proportion of the total return explained by local effects

should decrease. Our results presented evidence that during the first ten years after its

introduction, the euro had a major impact on the degree of integration of European

government bond markets. The main conclusions of our analysis were, on the one hand,

that markets of countries which shared a monetary policy were less vulnerable to the

influences of world risk factors and more vulnerable to EMU risk factors and, on the

other, that eurozone markets were only partially integrated with the Ger man market.

The proportion of the total return explained by country effects was still important and

investors were able to benefit from portfolio risk diversification.

An important restriction of the ACGP (2010) analysis was that, for each country,

we estimated ‘the average level’ of integration with the US and the Ger man bond

markets during the ten year period (1999–2008) and disregarded the fact that bond

market integration changes over time. Nevertheless, the financial market tensions that

started in August 2007 and were followed by a global financial and economic crisis led

to significantly rising yield spreads in European government bond markets along with

increased differentiation of country risk across the eurozone. This situation highlighted

the fact that bond market integration clearly changes in response to economic and

financial conditions, since the level of risk aversion changes and investors require

time-varying compensation for accepting a risky payoff from financial assets. For this

reason, some studies have allowed integration to vary over time and with events (see

Bekaert and Harvey, 1995, or Hardouvelis et al., 2006 among them).

This paper aims to address this question and to provide empirical evidence on

the ‘dynamic nature of bond market integration’ among EU-152(euro and non-euro

participants) and three economies from the central and eastern European (CEE) group

1Allen and Song (2005) investigatethe effect of European Monetary Union on the integ ration

of the financial services industry within Europe and f ind evidence that EMU has helped

financial integration within the euro area.

2With the exception of Luxembourg, due to the fact that its debt market is negligible.

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2011 Blackwell Publishing Ltd