Quantitative easing and the pricing of EMU sovereign debt

We study the pricing of EMU sovereign debt by a novel panel regression approach. This allows us to consider a comprehensive set of observable explanatory variables jointly with additional unobservable time-varying common factors. We add to the existing literature by considering the pricing effects of conventional as well as unconventional monetary policy and by controlling for possible variance risk premium effects. During the European sovereign debt crisis, unconventional monetary policy is found to have a pronounced spread decreasing effect, where policy elasticity is about three times larger than prior to the crisis. Furthermore, a rise in the variance risk premium significantly relates to spread increases. During the overall sample period, changes in country-specific bond market liquidity as well as aggregate market liquidity both help to explain yield spread variations. Three time-varying common factors account for about two-thirds of the variation in yield spread changes. The major component is a systematic risk factor, which captures a time-varying risk premium. The remainder factors help to explain bond valuations prior to and during the debt crisis.