EUROPE – Yield differences between Euro-zone government bonds have widened in some cases since the introduction of the euro, when they were expected to disappear like exchange rate risk, says a report by Frankfurt-based Deutsche Bank Research.

The report suggests that while absolute spreads are mainly down to varying degrees of liquidity in the national bond markets, the level of volatility found in the markets is sensitive to financial crises in emerging markets, heavily affecting less liquid markets. Spreads widened considerably in Euroland during the Russia crisis in 1998, as they did when the Brazilian real was allowed to float in 1999 and Turkey experienced recent financial and foreign exchange problems. The report comments that in each if these crises there was portfolio switching into markets that were considered low risk with high liquidity.

In the run-up to European monetary union (EMU), there was a considerable shrinking of the bond yields across the participant countries, but there was no further convergence after the introduction of EMU. In fact, most countries have seen yield spreads over Germany increase. The report says that the average spread of Euroland bonds, over 10 years and excluding Greece, over German government bonds, has risen from 17 basis points at the outset of EMU to 27 basis points as of June this year.

Overall, the report believes that international investors still do not perceive the European bond market as a single entity. In theory, investors should start looking at government bonds of the different EMU countries as complete substitutes, but this doesn’t happen.

Furthermore, national differences in rating and liquidity are still important,, since each EMU country remains liable for its own debt and bond issues. These are the main potential reasons that there hasn’t been further convergence in yield rates, the report believes.

But the ratings and liquidity differences have barely changed in the two and a half years since EMU, and national differences in rating and liquidity offer no explanation why there continues to be fluctuations in rate spreads, as neither do other potential influences, such as inflation, GDP growth and absolute interest rates.