This paper aims to investigate how the information conveyed in the European Central Bank’s (ECB) monetary policy announcements affects the Credit Default Swaps (CDS)-bond basis swap across major euro area sovereign bond markets. In addition, this paper examines the time variation as well as the amount and direction of the CDS-bond basis connectedness within these debt markets.
The analysis uses daily data from March 2016 to December 2021, capturing various episodes of distress in sovereign markets. This study used a robust array of tests, incorporating event study analysis, the Granger causality test and a time-varying parameter vector autoregression frequency approach. These varied methodologies enabled us to effectively capture multiple aspects of the dynamics of CDS-bond bases as well as the relationships between various markets.
Preliminary results indicate that Germany exhibits only significant responses to unconventional monetary policy, suggesting that conventional monetary policy appears to be particularly effective in explaining the CDS-bond basis dynamics of France, Italy and Spain. These findings align with the prevailing understanding that the CDS-bond basis cannot be fully explained by country-specific or global variables that typically account for credit spreads. This outcome enables us to test the hypothesis that suggests that the mere presence of a regional common factor, such as the ECB’s monetary policies, can underpin the existence of comovements among CDS-bond bases in the sovereign bond markets of the euro area. Importantly, the analysis demonstrates sizable comovement among markets. Furthermore, the total spillover in the frequency domain indicates that shocks are processed and transmitted within a relatively short time frame. As a robustness check, this paper found that the ECB’s unconventional monetary measures led to a surge in the short-term area’s spillovers across the euro area’s markets.
This study is original in its in-depth examination of the dynamics of CDS bases, focusing on two critical dimensions: the effects of monetary policy and spillover shocks. By examining how shifts in monetary policy affect CDS bases, as well as how shocks are transmitted across markets, this paper uncovers the intricate relationships and mechanisms at play. This dual focus enhances the understanding of how monetary actions and market interconnections affect CDS bases in the euro area.
