Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

• European sovereign CDS spreads escalated following the Global Financial Crisis.
• We investigate whether this can be explained by fundamental and momentum trading.
• A model of CDS spreads with heterogeneous expectations is estimated for thirteen countries.
• Fundamentals played a role for core EU countries but to a lesser extent for peripheral countries.
• Momentum trading has played a destabilizing role for spreads of all investigated countries.

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.