The impact of EMU on bond yield convergence: Evidence from a time-varying dynamic factor model

This paper examines the dynamics of long term sovereign bond yields for 21 OECD countries. Following Del Negro and Otrok (2008), we estimate a dynamic factor model, with time varying parameters and stochastic volatility, that decomposes the observed variation in bond yields for each country into a common factor, a regional factor (EMU/non-EMU), and an idiosyncratic country specific factor. We find that prior to the financial crisis of 2008, the common factor played a dominant role for most countries in our sample. In the post financial crisis period there is substantial heterogeneity in the relative importance of the EMU and the idiosyncratic factors across different countries. For instance, our results suggest that there was a decoupling between the EMU and bond markets of the periphery economies of Greece, Ireland and Portugal in the post-2008 period. We find that after the onset of sovereign debt crises in these economies, the idiosyncratic factor assumed an important role in driving the bond yield variation. Thereafter, the EMU's share in bond yield changes in Ireland and Portugal increased considerably since 2012, whereas for Greece the idiosyncratic factor continued to play a significant role in driving bond yields. In contrast, the EMU factor consistently played a dominant role in explaining bond yield changes in Italy and Spain, the other two economies that also experienced severe debt crisis during this period. We argue such differences in the importance of the EMU factor between core and periphery economies can be attributed to the systemic importance of core members for the EMU. This is indicated by our finding that bond yields and credit default swap (CDS) are less sensitive to changes in debt-GDP ratios in countries where the EMU factor played a larger role in the post-2008 period.