Understanding liquidity in the euro area sovereign bond market

Abstract

Objectives of the study This thesis provides a comprehensive study of the time-series behavior of liquidity in the euro area sovereign bond market. The focus of the analysis is threefold. First, I investigate whether bond liquidity exhibits commonality across countries - that is, comovement in the bid-ask spreads of different sovereigns' securities. Second, motivated by recent theories relating liquidity dry-ups to the capital constraints of financial intermediaries, I test whether "liquidity spiral" dynamics are present in the eurozone sovereign debt market. Third, I study the importance of supply-side, demand-side, and market condition related factors in determining the liquidity movements of euro area government bonds.

Data The data set consists of 296 separate bonds issued by the EMU member states with active sovereign debt markets. The sample time period is from December 30th 2011 to December 31st 2015, spanning 1045 trading days.

Findings of the study The thesis presents three key findings. First, the euro area sovereign bond market exhibits relatively high levels of cross-country commonality, i.e. there seems to be a common factor in liquidity across the monetary union. The sensitivity of country-specific bond liquidity to market-wide bond liquidity is more pronounced in times of market distress, characterized by high investor uncertainty and concerns about sovereign credit risk in the euro area. Second, there are "liquidity spiral" dynamics in the eurozone sovereign bond market - market-wide bond liquidity tends to decrease following tightened funding conditions and increased bond market volatility. Third, bond liquidity tends to be driven mainly by demand-side and market condition related factors, rather than by supply-side forces. More precisely, liquidity in the euro area sovereign bond markets decreases with increasing investor uncertainty, lower returns and higher volatility in the bond market, decreasing liquidity in the foreign exchange market, and recent rising liquidity in the bond market.