European Spreads at the Interest Rate Lower Bound

Abstract

This paper analyzes the effect of the interest rate lower bound on long term sovereign bond spreads in the Euro area. We specify a joint shadow rate term structure model for the risk-free, the German and the Italian sovereign yield curves. In our model, the behavior of long term spreads becomes strongly nonlinear in the underlying factors when interest rates are close to the lower bound, which in the data occurs since the beginning of 2012. We fit the model by Quasi-Maximum Likelihood and highlight three important consequences of sovereign spreads’ nonlinear behavior: i) their distribution is skewed, ii) they are affected by (possibly exogenous) changes in the lower bound, and iii) they become less informative about the countries’ sovereign risk. Shadow spreads, however, still provide reliable information.