By Vassilios G. Papavassiliou, Assistant Professor of Finance, University College Dublin
Sovereign bonds play a crucial role in the financial system, representing a key reserve asset for central banks and a profitable investment asset for investors and portfolio managers (Papavassiliou, 20211). All markets for sovereign bonds worldwide experienced a period of impaired functioning from February to March 2020 resulting from the COVID-19 pandemic crisis, which quickly spilled over to other markets (for example, the S&P 500 [Standard and Poor’s 500] and the Euro Stoxx 50 indices lost more than one-third of their values) and adversely affected funding conditions and market liquidity (Schrimpf et al., 20202).
The COVID-19 crisis was a shock to the real economy that rebounded into financial markets3. The euro area’s sovereign bond market, in particular, was seriously affected by the COVID-19 frenzy during the last week of February 2020, when the first lockdown measures were imposed in Europe (Zaghini, 20214). There was an extremely high demand for cash and near-cash assets at the time, culminating during the “dash for cash” episode from March 11 to March 23, 2020. During that period, the increased demand for liquidity and concerns about the global economic outlook resulted in massive sell-offs of financial assets, even of the safest and most liquid ones (such as sovereign bonds), increasing risk aversion across all income levels. The market depth for sovereign bonds declined to extremely low levels, similar to those witnessed during the euro area sovereign debt crisis of 2009-12, and was accompanied by increases in bond transaction costs in all inter-dealer markets.
Apart from deteriorating liquidity conditions, the euro area’s sovereign bond prices of both on-the-run and off-the-run benchmarks experienced large declines, including price declines for their futures contracts. The price drops drove yields up (bond prices and yields are inversely related), reflecting the uncertainty in financial markets. Figure 1 visually illustrates daily euro area spot yields for AAA-rated central government bonds across five maturity segments: 2-, 5-, 10-, 20- and 30-year maturity bonds. The sample period spans the dates from July 2019 to December 2020. The grey-shaded area covers the period from February to March 2020, including the “dash for cash” episode. It is evident that the yields of all benchmark bonds, especially those of the 2-, 5- and 10-year maturity segments, skyrocketed above the peaks reached before the COVID-19 crisis. Studying the yields of government bonds is of substantial importance as yields affect required rates of return for investors and decision making for portfolio allocation strategies.
Figure 2 plots the quoted spread for the Spanish 10-year benchmark bond. The quoted spread is the difference between the simple average of the three best ask prices and bid prices. The liquidity dry-ups that were witnessed between February and March 2020 reached extraordinarily high levels that are comparable to those that occurred during the euro area sovereign debt crisis (a detailed discussion of liquidity conditions in the euro area’s sovereign bond market during COVID-19 is provided by Papavassiliou and Xia, 20235).
Spreads could have increased more if not for the speedy and sizable policy response of the European Central Bank (ECB). On March 18, 2020, the ECB launched the Pandemic Emergency Purchase Programme (PEPP), a €750-billion, non-standard asset purchase programme that alleviated market stress and restored investor confidence. The ECB took additional monetary policy measures, including lowering long-term interest rates forrefinancing operations, injecting liquidity into banking institutions and temporarily relaxing various regulatory restrictions.
Figure 1. Daily euro area spot yields for AAA-rated central government bonds across five maturity segments. The sample period spans the dates from July 2019 to December 2020. The grey-shaded area covers the period from February to March 2020, which includes the “dash for cash” episode.
It is evident from Figure 1 and Figure 2 (below) that the aforementioned policy measures succeeded in alleviating market stress and restoring market participants’ confidence. Bond yields fell to normal levels toward the end of 2020, whilst bid-ask spreads dropped substantially immediately after the ECB’s interventions. By August 2020, the majority of benchmark bonds had recovered most of the losses experienced during February and March. The COVID-19 financial crisis could have been much worse if the ECB hadn’t responded promptly. In contrast to the ECB’s slow and indecisive response during the euro area debt crisis, the success of its actions during the pandemic was mainly due to the flexibility with which the various measures were implemented, the complementarity of those measures and the role fiscal policy played in resolving the economic downturn6.
Figure 2. The daily quoted spread for the Spanish 10-year benchmark bond. The sample period spans the dates from July 2019 to December 2020. The grey-shaded area covers the period from February to March 2020, which includes the “dash for cash” episode.
Various lessons have been learned from the COVID-19 crisis. Europe must have an effective operational risk management plan in place before another shock hits financial markets. Being able to identify systemic risks and vulnerabilities at an early stage—an early warning system—should be prioritised among policymakers and regulators. It is also important for Europe and other countries to have effective cross-border cooperation and information sharing7.
Building on the experiences from previous financial crises, European banks were better prepared to deal with a new crisis, held more capital and were less leveraged than in previous years, allowing them to prevent contagion effects (banks have to hold a substantial amount of sovereign bonds under the liquidity coverage ratio [LCR]). The Asset Purchase Programme (APP) was designed with more flexibility than the corresponding programme implemented during the 2009-12 debt crisis and, with the support of fiscal policy, was more successful in preventing a new crisis from unfolding.
1 European Capital Markets Institute (ECMI): “Euro area sovereign bond yields during the Covid-19 pandemic: What do they tell us?”, Vassilios G. Papavassiliou, October 12, 2021, Centre for European Policy Studies (CEPS).
2 Bank for International Settlements (BIS): “Leverage and margin spirals in fixed income markets during the Covid-19 crisis,” Andreas Schrimpf, Hyun Song Shin and Vladyslav Sushko, April 2, 2020, BIS Bulletin No 2.
3 Investment Company Institute (ICI): “Report of the COVID-19 Market Impact Working Group: The Impact of COVID-19 on Economies and Financial Markets,” October 2020, Washington, DC.
4 European Central Bank (ECB): “The Covid pandemic in the market: infected, immune and cured bonds,” Andrea Zaghini, June 2021, ECB Working Paper No. 2563.
5 University College Dublin (UCD): “Liquidity in the euro-area sovereign bond market during the ‘dash for cash’ driven by the COVID-19 crisis,” Vassilios G. Papavassiliou and Fan Dora Xia, 2023, Working Paper.
6 European Central Bank (ECB): “Lessons from an Unusual Crisis: Speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the Federal Reserve Bank of New York conference on ‘Implications of Federal Reserve Actions in Response to the COVID-19 Pandemic’,” October 1, 2021.
7 Financial Stability Board (FSB): “Lessons learnt from the COVID-19 pandemic from a financial stability perspective: Final report,” October 28, 2021, Discussion.