Neglected Risk: Evidence from the Eurozone Sovereign Credit Market

Abstract

We find evidence of neglected risk during sovereign debt expansions (DE), by analyzing the sovereign credit market for both crisis and noncrisis Eurozone countries from 2002-2017. We show that whereas DE predicts increased default probability, large DE predict negative future risk premia. Using panel regressions with several control variables, including risk appetite, we then document a negative association between DE and risk premia. Using the shock of the Deauville summit in October 2010 we document its impact using panel regressions one year before and after the event, and find further evidence of neglected risk before but not immediately after Deauville. Finally, analyzing the most recent data (2011-2017) we show that DE still predicts lower risk premia, but this effect is neutralized by quantitative easing, raising the public policy question of what will happen with the end of quantitative easing.