Fundamental drivers of

Eurozone sovereign

spreads

Markets and Products Analysis

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The 10-year government bond yield of the periphery countries increased sharply during 2011-2012. The Portuguese

10-year yield reached 17.4% (30/01/2012) after S&P downgraded the sovereign credit rating on January 13. Italy’s

yield increased in November 2011 at a high 7.3% and Spain’s yield at a high 7.6% (24/07/2012).

During the �financial crisis, the German Bund has benefitted from the safe haven status.

The ECB measures announced at the beginning of 2015, have significantly lowered bond yields.

Eurozone Sovereign Spreads

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%

Selected Eurozone Countries 10-Year Govemrent Bond Yield, 2009 - 2016

Germany Portugal

Spain Italy

France Belgium

Netherlands

Source: Bloomberg, Market and Products Analysis

Spreads limited increase in July 2015 was caused

by Grexit worries (Referendum in Greece) and a

possible contagion effect on other Eurozone

countries. Specifically:

• Italy’s yield reached high (162bp) since Nov

2014.

• Spain’s yield increased to a high (161bp)

since July 2014.

• France’s yield increased to a high (48bp)

since May 2014.

In August 2015, German bund benefitted from the

risk off environment due to uncertainty regarding

China’s economic outlook. As a result, Italy (24/08:

130bp) and Spain (21/08: 144bp) sovereign

spreads widened.

Negative risk sentiment in December mainly due to

markets disappointment after ECB’s meeting and

Fed’s rate hike. Sovereign spreads in periphery

Eurozone’s countries exhibited mild increase in

December.

Increased probability for further monetary easing

measures by the ECB after the meeting in

January, contributed to decrease in Spain’s spread

versus Germany.

Eurozone Sovereign Spreads

4 Source: Bloomberg, Market and Products Analysis

70

90

110

130

150

170

190

210

230

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10-Year Government Bond Yield Spread vs Bund, 2014-2016

Italy Spain

10

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25

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45

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55

60

65

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75

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France 10-Year Government Bond Yield Spread vs Bund, 2014- 2016

Most Eurozone countries improved their credit worthiness in 2015.

Eurozone Credit Rating

5 Source: Bloomberg, Market and Products Analysis

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S&P Long Term Credit Rating

Spain Greece Ireland

Italy Belgium Portugal

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

B+

B

B-

CCC+

CCC

CCC-

CC

C

SD

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

B+

B

B-

CCC+

CCC

CCC-

CC

C

SD

Average sovereign credit rating (S&P, Fitch, Moody’s) is explained well by markets credit spread (swap spread).

Current sovereign credit spread in Italy and Spain theoretically implies higher swap spread.

Eurozone Sovereign Spreads vs Credit Rating

6 Source: Bloomberg, Market and Products Analysis

Italy

Portugal

Ireland

Spain

Germany

Belgium

France

Austria

Netherlands Finland

y = -0.0443x + 19.901 R² = 0.8226

-40 -20 0 20 40 60 80 100 120 140 160 180 200 220 240

Selected Eurozone countries credit rating versus 10-Year swap spread

AAA

AA+

AA

AA-

A+

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-

Eurozone Economic Growth Outlook

Economic growth outlook for 2016 is expected to

remain solid, supported by the factors below:

Lower oil price

ECB QE measures

Euro currency devaluation

The IMF forecasts growth of 1.7% this year in

Eurozone.

Yield spreads increase as a response to a slowdown

in growth. In contrast, a solid growth performance is

assumed to improve creditworthiness, reducing

government bond spreads.

PMI manufacturing index is used as a proxy for the

economic activity. Recent data indicate a possible

reduction of spreads in 2016.

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15

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15

Eurozone Countries PMI Manufacturing Index, 2013 - 2015

Germany Spain France

Greece Ireland Italy

Source: Bloomberg, European Commission, Market and Products

Analysis

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

Eurozone Germany France Italy Spain Greece Portugal

% EC Forecast: GDP annual growth

2015

2016

Eurozone Countries Financing Needs 2016

Countries with high maturity debt profile may

exhibit high volatility in bond yield spreads.

Italy’s maturing debt (bonds and T bills) in

2016 is estimated around 290 bln euros.

Italy (25.4%) and Spain (18.8%) exhibit

higher financing needs as a percent of GDP

in 2016.

Recent risk off environment affects positively

german government bonds due to safe

haven status (AAA).

The decrease in long-term debt issuance in

most euro area countries may associate with

lower yield spreads.

8

Country Maturing Debt Budget deficitFinancing

Needs

Italy 23.4 2.0 25.4

Spain 15.6 3.2 18.8

France 13.7 3.4 17.0

Portugal 15.4 2.7 18.2

Belgium 15.0 2.3 17.3

Netherlands 9.5 1.8 11.3

Slovenia 15.7 5.3 21.0

Greece 3.7 3.6 7.3

Austria 5.2 1.7 6.9

Germany 5.6 -0.3 5.3

Finland 6.2 2.8 9.0

Ireland 5.8 1.3 7.1

2016

Financing Needs % GDP

0

15,000

30,000

45,000

60,000

75,000

90,000

105,000

120,000

135,000

150,000

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€ m

ln.

Selected Eurozone Countries Maturing Debt 2016

Italy Germany

France Spain

Belgium Portugal

Source: Bloomberg, IMF, Market and Products Analysis

Eurozone Countries Fiscal Data

The fiscal position is a proxy for creditworthiness.

The higher fiscal deficit denotes higher financing

needs. High debt issuance due to fiscal deficit

financing is expected to affect positively spreads.

A rise of fiscal deficit would be followed by the need

for fiscal consolidation program, which would have

negative spillover effects on economic outlook.

During the debt crisis, markets penalize fiscal

imbalances more strongly, attaching an extra

premium of projected public debt.

Sovereign debt becomes riskier during periods of

economic slowdown. The higher the uncertainty,

the greater the expected spreads, due to the risk of

default.

9

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2008 2009 2010 2011 2012 2013 2014 2015 2016

Pe

rce

nta

ge

of

GD

P

Fiscal Balance of Eurozone Countries (2008-2016)

Greece

Portugal

Spain

Italy

30.0

50.0

70.0

90.0

110.0

130.0

150.0

170.0

190.0

210.0

230.0

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Perc

en

tag

e o

f G

DP

Government Debt of Eurozone Countries (2007-2016)

Greece

Italy

Spain

Portugal

Source: Bloomberg, Market and Products Analysis, IMF

ECB’s Measures Impact on Government Bond Market

The expanded asset purchase programme consists of

third covered bond purchase (CBPP3), asset-backed

securities purchase (ABSPP) and public sector

purchase (PSPP). Monthly purchases in public and

private sector securities amount to €60 bln..

In 2015, the ECB purchased €495 bln. under PSPP.

ECB allocates €115 bln. of the total purchases to

German bunds and €79 bln. to Italian bonds.

Bond purchases have weighted average maturity 8

years, indicating that the impact of the QE is higher

on 10 years bonds versus short-term bonds.

QE pushes up the market price of government bonds

and reduces yields.

After the last meeting of ECB, the President stated

that it is necessary to reconsider the monetary policy

in the next meeting in March. A possible deposit rate

cut affect the short term bond yields (2y) further.

In case that the ECB decides to expand the size of

purchase programme, the 10-year government bond

yields expect to decrease substantially.

10

Breakdown of debt securities under PSPP

15-Dec Cumulative net purchases

in mln euro

Weighted average

remaining maturity in

years

Austria 12,641 8.5

Belgium 15,896 9.5

Cyprus 285 5.8

Germany 115,625 7.0

Estonia 48 2.5

Spain 56,817 9.7

Finland 8,086 7.6

France 91,767 7.7

Ireland 7,583 9.4

Italy 79,209 9.3

Lithuania 1,107 6.0

Luxembourg 1,115 6.1

Latvia 684 5.9

Malta 282 9.6

The Netherlands 25,612 6.5

Portugal 11,220 10.4

Slovenia 2,228 8.0

Slovakia 4,622 8.6

Supranationals 60,104 7.0

Total 494,930 8.0

Source: Bloomberg, Market and Products Analysis

Recent Markets Turmoil and Sovereign Spreads

Risk sentiment plays an important role in bond

markets. Core countries government bonds

(Germany, Finland, Netherlands) are considered as

safe heaven assets, implying low bond yields in case

of risk-off environment. In contrast, periphery

countries bonds exhibit positive correlation with risky

assets.

VIX is a measure of implied volatility of S&P 500

index. High VIX readings indicate significant risk off

sentiment.

Recent elevated VIX was combined with increase of

sovereign spreads in periphery countries.

German 10-year Government bond yield dropped on

February 1 2016 to a low (0.304%) since April 2015,

mainly due to safe heaven status and the expectation

that the ECB will cut the deposit rate.

Major political risks in 2016:

More than one month after the parliamentary

elections in Spain, a new government is still not

in sight. A possible left wing alliance would have

a significant negative effect on bonds due to

increased risk of loose fiscal policy and Catalan

secession. Possible new elections in spring.

Refugee crisis could affect German political

landscape in 2016.

Political instability drives bond yields higher.

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0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Spreads & political index of Portugal (2005-2014)

Portugal spreads

Political index

85

90

95

100

105

110

115

120

125

130

135

140

10

15

20

25

30

35

40

45 Italy - Germany 10-Year Government Bonds Yield Spread & VIX index, 2015 - 2016

Implied Volatility Index (Vix)

Italy 10-Year Spread

Source: Bloomberg, Market and Products Analysis

Performance Bonds YtD

Since the start of the year, Eurozone core

countries (Germany, Netherlands) 10-Year

government bonds have exhibited significant

gains (around 3.5%), mainly due to increased

demand for low risk assets.

Spain 10-Year government bonds underperformed

vs Bund since the beginning of the year, mainly

due to political instability after the general

elections.

Greece government bonds dropped substantially

in 2016 due to uncertainty regarding the

conclusion of the review.

The revived expectations that the ECB will adopt

further monetary easing measures as well as the

projections that the Fed will delay its second rate

hike, support Eurozone government bonds.

Demand for periphery Eurozone government

bonds remains solid, mainly due to ECB monetary

measures.

12 Source: Bloomberg, Market and Products Analysis

-9.0 -8.0 -7.0 -6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0

Germany

Netherlands

France

Finland

Austria

EFSF

Spain

Italy

Slovenia

Slovakia

Cyprus

Greece

10-Year Government Bond Price YtD Change (%)

As of Feb. 1, 2016

Econometric model

Our econometric model focuses on:

The determinants of 10-year government bond yields versus Germany

A panel data analysis

A 2SLS method of estimation

Our analysis, examines:

The evolution of the fundamental drivers of Eurozone sovereign spreads.

The evolution of spreads in the Eurozone.

The sensitivity of spreads to fundamentals, using an econometric model based on panel data methods.

The results largely agree with existing literature.

13

Spreads(-1) spreads

Government debt spreads

Industrial prod. spreads

Volatility spreads

ECB assets spreads

Results From Econometric Model

14 Source: Market and Products Analysis

Conclusion

15 Source: Market and Products Analysis

Outlook

Economic

activity

Government

debtCPI Political risk

ECB total

assetsVIX

Spreads vs

German

Italy 1 0 0 0 1 1 -1

Spain -1 1 0 2 1 1 1

Portugal 0 0 0 1 1 1 0

France 1 1 0 0 1 1 0

Explanatory variables outlook 2016

Base Case Scenario Assumptions:

• High markets volatility will probably remain in place in 2016.

• Increased political risks in Spain due to no majority in parliament.

• Stable economic growth in Eurozone around 1.7% in 2016.

• The ECB may cut the deposit rate at its March meeting. Low probability that the ECB will decide to expand the size of

its QE programme in 2016.

• Fiscal position in most countries the same as in 2015. Government debt as a percent of GDP is expected slightly

higher in Spain and France.

• Low inflation environment will continue in 2016 due to drop of oil price.

Taking into account the above mentioned assumptions we estimate that:

• Spain’s spread vs Bund may widen in 2016 (Feb. 1 2016: 119 bps), mainly due to political uncertainty.

• Italy’s sovereign spread (Feb. 1 2016: 108 bps) is estimated to tighten until the year end due to improved economic

outlook.

• Portugal’s 10-year government bond yields spread vs Germany may be in range (Feb. 1 2016: 257 bps), as economic

activity will remain supportive in 2016. In case, markets volatility is higher than in our base case scenario, Portugal will

be more vulnerable than other Eurozone countries.

• France’s spread vs Bund is expected to remain close to current levels (Feb. 1 2016: 32 bps), however, upside risks

may arise during the 2016 due to negative fiscal data outlook.

Appendix: Econometric model

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8 euro area countries (Austria, Belgium, Greece, Italy, Spain, Netherlands, Portugal, France).

10-year period (2005-2015) in monthly frequency.

Balanced long panel with big T (time period), small N (number of countries).

Explanatory variables: first lag of sovereign spreads, vix, total assets of ECB, fiscal balance, government debt,

inflation, industrial production.

Descriptive statistics are presented below.

Appendix: Data

17

Model:

𝑠𝑝𝑟𝑒𝑎𝑑𝑠𝑖𝑡 = 𝑐 + 𝛽1𝑠𝑝𝑟𝑒𝑎𝑑𝑠𝑖𝑡−1 + 𝛽2𝑐𝑝𝑖𝑖𝑡 + 𝛽3log_𝑣𝑖𝑥𝑡 + 𝛽4log_𝑒𝑐𝑏𝑡 + 𝛽5𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑖𝑡

+𝛽6𝑑𝑒𝑏𝑡𝑖𝑡 + 𝛽7𝑖𝑛𝑑𝑢𝑠𝑡_𝑝𝑟𝑜𝑑𝑖𝑡 + 𝛼𝑖 + 𝜀𝑖𝑡

𝛼𝑖 = country specific effect

𝜀𝑖𝑡 = transitory error term

2SLS process

Fixed effects estimation

Cross section weights which accounts for heteroskedasticity

Account for endogeneity: set of instruments

Appendix: Methodology 1

18

Description of the 2SLS (instrumental variables) process:

First stage:

𝑒𝑛𝑑𝑜𝑔𝑖𝑡 = 𝑑 + 𝛾1𝑠𝑝𝑟𝑒𝑎𝑑𝑠𝑖𝑡 + 𝛾2𝑖𝑛𝑠𝑡𝑟𝑖𝑡 + 𝑢𝑖𝑡

Where: 𝑒𝑛𝑑𝑜𝑔𝑖𝑡 = endogenous variables

𝑖𝑛𝑠𝑡𝑟𝑖𝑡= instrumental variables

The goal of the method is to find a proxy for the endogenous variables that will not be correlated

with the error term.

Second stage:

𝑠𝑝𝑟𝑒𝑎𝑑𝑠𝑖𝑡 = 𝑒𝑛𝑑𝑜𝑔 𝑖𝑡 + 𝛽𝑖𝑠𝑝𝑟𝑒𝑎𝑑𝑠𝑖𝑡

Appendix: Methodology 2

19

Appendix: Results

20

Contact

210-3282791 marketanalysis@alpha.gr

Panos Remoundos panos.remoundos@alpha.gr Maria Koutouzi maria.koutouzi@alpha.gr Ioannis Kouravelos, CFA ioannis.kouravelos@alpha.gr Konstantinos Anathreptaκis konstantinos.anathreptakis@alpha.gr Niki Konstantopoulou niki.konstantopoulou@alpha.gr

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