Are European Sovereign Bonds Fairly Priced? The Role of Modeling Uncertainty

Abstract

This paper examines the extent to which large swings of sovereign yields in euro area countries during the sovereign debt crisis can be attributed to fundamentals. We focus on the inherent uncertainty in bond yield models, which is often overlooked in the literature. We show that the outcomes are strongly affected by modeling choices with regard to i) the confidence bands for the model prediction, ii) the assumption whether the model coefficients are similar across countries or not, iii) the sample selection, iv) the inclusion of financial variables and v) the choice of time-varying coefficients. These choices affect the explanatory power of macro fundamentals and the extent of mispricing. We find substantial misalignment compared to fundamentals for Greek yields, in most specifications also for Portugal and Ireland, but for the other EMU countries, including Spain and Italy, the evidence is less clear cut. This calls for modesty in interpreting bond yield models and for cautiousness when using them in policymaking.