Mispricing of debt expansion in the eurozone sovereign credit market

Abstract

We find evidence consistent with risk mispricing in the eurozone sovereign credit market for crisis and non-crisis countries alike, using a novel variable of sovereign debt expansion (DE) that we construct. DE predicts increased default probability, but panel regressions from 2002 to 2017 show a negative association with risk premia, even when controlling for risk appetite and the known determinants of sovereign risk premia. As expected, the negative association was only briefly interrupted by the 2010 Deauville Summit, but it resumed by the onset of the 2011 eurozone crisis. The introduction of quantitative easing in 2015 mutes the negative association, raising the concern of what will happen once quantitative easing ends. Our finding is robust to several model specifications.