Variables

The variable to be explained is the sovereign bond spreads that we show either by USSPREADit if the yields are over the US treasuries or by LSPREADit if the yield

spreads are calculated over the local government bonds with the same maturity. For the Eurozone region we calculate the local bond spreads over German government bonds yield since they use the same currency (See Bernoth and Erdogan, 2012; D’Agostino and Ehrmann, 2014). The Bloomberg Sovereign Bond Indices used in this study are the market-value-weighted indices measuring the fixed-rate local currency public obligations of 24 developed countries. 4 _The

4_{.http://www.bloombergindexes.com/content/uploads/sites/3/2014/05/Global_Developed_Sovereign_Bond_Inde}

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quality of these indexes is between B and AAA and the average maturity fluctuates between 4.34 years for Hong Kong to 15.49 years for UK. For calculating the yield spreads we use the 5-year or 10-year local or US government bonds depending on which one is closer to the maturity of each country’s sovereign bond index. For controlling the regional effect we apply two methods. First we include region dummy variables to the model to find how it may change the results. Second we also construct a panel for each region and analyze each panel results specifically. In this study we consider monthly frequency data because of the availability of macroeconomic variables. Regarding the previous fixed income literature, we select eight independent variables to examine if they are able to determine the bond spreads. The first four explanatory variables are domestic vectors and the last four are vectors for global variables for country i at time t, respectively.

As the proxies for the domestic macroeconomic fundamentals, the first variable that we use is Inflation (CPI) measured by log of consumer price index. Inflation plays an important role in the economy and it may affect the default risk as well. In one hand, since the higher inflation reduces the real value of domestic sovereign debt, it may negatively determine sovereign default. On the other hand, inflation will depreciate the domestic currency against the US dollars. Thus the higher inflation decreases the government’s ability to pay back debt in US dollar with the local fund indicating a positive relationship between the inflation rate and the

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sovereign yield spread. In addition, since all the Eurozone countries face the same monetary policy made by European Central Bank (ECB), the impact of inflation in Eurozone countries may be different compared to other regions. (See Boehmer and Megginson, 1990; Min 1998; Baek, et. al., 2005, Eichler, 2014)

The second domestic variable, Inflation variation (INFV) is a quadratic deviation of inflation from long term means. A high variation of inflation may increase the costs and make debt service more difficult (See Lemmen and Goodhart 1999 and Maltritz 2012). Therefore, we expect a significant negative sign for the coefficients of Inflation variation.

We also use the log of Industrial Production (IP) as a proxy for local business cycle fluctuations or the variation in economic activity. (See Ozatay et al., 2007; Gilchrist et al., 2009) We hypothesize a negative and significant sign for the log of Industrial Production in our models.

The last domestic variable is Country credit ratings (RATING) measured by sovereign credit ratings (See Kamin and Kleist, 1999; Erb et al., 2000 and Sy, 2002; Gueye and Sy, 2013) as a proxy for the domestic macroeconomic fundamentals. Cantor and Packer (1996) investigate the factors that determine the sovereign ratings. The results indicate that the impact of the per capita income, GDP growth and Economic development on sovereign ratings is significant and positive. On the other hand, the increase in the rate of inflation, external debt and

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default history will significantly decrease the sovereign rating. They conclude that the sovereign ratings behave as the aggregate macroeconomics indicators and therefore have stronge correlation with the credit spreads.

The credit rating variable (RATING) is constructed based on Moody’s rating for long-term debt in domestic currency. 5 Afonso et al. (2007) conclude that the set of variables include real GDP, government debt, government effectiveness, external debt, external reserves and default history that are linked to determine the ratings, are actually among the main factors explaining sovereign spreads. We hypothesize a positive significant coefficient for this variable, as the decrease in rating indicates the collapse in the economic stability and consequently an increase in spreads. (See Gueye and Sy, 2013)

Global financial conditions are proxies by a few variables as well. The first variable is an aggregate measure of US macroeconomic conditions called the Aruoba-Diebold-Scotti Index (ADSI)6_{, which is designed to track real business}

conditions at a high frequency (See Aruoba et al., 2009). We expect a significant and negative relationship between the bond spread and ADSI factor.

5 _{For assignment of numerical values to credit ratings, we assign 1 to the worst credit rating and 22 to the best.}

6_{The Aruoba-Diebold-Scotti business conditions index is designed to track real business conditions at high frequency. Its}

underlying (seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment, industrial production, personal income less transfer payments, manufacturing and trade sales; and quarterly real GDP) blend high- and low- frequency information and stock and flow data. http://www.philadelphiafed.org/research-and-data/real-time-center/business- conditions-index/

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The second global variable is The Conference Board US lagging leading indicator7 as the proxy of the U.S. economy or Global Business Cycle. The lagged leading indicator usually increases at the middle of a recession and it indicates the downturn in the global economy. (See Huang and Kong, 2003; Ozatay et al., 2007) We therefore expect a positive and significant sign for its coefficient.

In order to study market sentiments toward risk and global risk appetite, we include the spread of high yield US corporate bonds provided by Bloomberg over US treasuries. (See Codogno et al.,2003 ; Bernpth and Erdogan, 2012; Maltritz, 2012; D’Agostino and Ehrmann, 2014). Maltritz (2012) finds a high inclusion probability of about 99%, by including BBB-rated US corporate bonds over US treasuries as indicator of market sentiment in determining the sovereign yields spreads of EMU members using Bayesian Model Averaging. We hypothesize that this spread (HYS) is positively correlated with the sovereign bond spreads. (See D’Agostino and Ehrmann, 2014)

We also use log of VIX index (VIX), measure of implied volatility of S&P 500 index which is interpreted as the proxy of investor risk aversion and overall financial markets risk in the future (See Hartelius et al. 2008; Longstaff et al, 2011; Gueye and Sy 2013; Eichler , 2014). We hypothesize that this proxy for financial

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markets risk should positively relate to the sovereign bond spreads, since more risk aversion increases spreads.

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Table 2.1

Variables Defenition Proxy of Source Expected Sign

USSPREADLog of Bloomberg Sovereign yield spreads over the US treasury bonds Sovereign yield spreads Authors' calculations based on Bloomberg data Dep. Var. LSPREAD Log of Bloomberg Sovereign yield spreads over the local government bonds Sovereign yield spreads Authors' calculations based on Mloomberg data and FRED

(Federal Reseve bank of St.Louise ) Dep. Var.

CPI Log of Consumer Price Index Inflation The World bank database -

INFV Inflation variation is a quadratic deviation of inflation from long term mean Inflation variation Authors' calculations based on The World bank database -

IP Log of Industrial Production Local business cycle fluctuations The World bank database -

RATING Sovereign credit ratings Country credit ratings Authors' calculations based on Moody’s data.

Local currency rating of long-term debt. 1=Default , +

ADSI The Aruoba-Diebold-Scotti Index (ADSI) US macroeconomic conditions Federal Reserve Bank of Philadelphia -

CONFB The Conference Board US lagging leading Economic indicator, include

economic variables that tend to move after changes in the overall economy. Global Business Cycle Bloomberg Database + HYS The spread of high yield US corporate bonds over US treasuries Market sentiments toward risk / Global risk appetite Bloomberg Database +

VIX Log of implied volatility of S&P 500 index Investor risk aversion and overall market risk Bloomberg Database +

Variables Description

Note. This table provides the definition , the source and the expected sign of the coefficient for the variables in the current study. Our sample includes the monthly data from 24 developed countries in 5 regions from Jan 2010 to March 2015. The Bloomberg Sovereign Bond Index is a rules-based market-value-weighted index engineered to measure the fixed-rate local currency public obligations of developed countries. The index is USD- based and contains issues from the U.S., Canada, Europe and Pacific Rim countries. There is no rating restriction for inclusion. To be included in the index, a security must have a maturity of greater than 1 year at rebalancing. Minimum par amounts are 1 billion (USD, CAD, EUR, AUD, NZD, SGD), 5 billion (DKK, NOK, SEK), 500 million (CHF, GBP, HKD) and 200 billion (JPY).

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