Non-technical summary of ESM Working Paper 63: Dangerous liaisons? Debt supply and convenience yield spillovers in the euro area

In advanced economies, public spending needs are rising, primarily driven by demands for the green transition, care for ageing populations, and enhanced resilience in light of geopolitical risks. Meeting these needs will require governments to continue borrowing at low interest rates to avoid high debt servicing costs. Convenience yields—a premium on sovereign bonds due to their safety and liquidity—help keep these rates low, but questions arise about whether these yields can continue supporting low-interest debt issuance. While past research has shown that increased debt in one country decreases its convenience yield, less is understood about the potential spillover effects of one country’s debt issuance on the convenience yields in neighbouring countries.

The paper finds that a country’s debt issuance impacts convenience yields across borders. For instance, an increase in German debt reduces its convenience yield and causes nearly proportional decreases in other "safe" countries’ convenience yield (e.g., in France, the Netherlands, and Finland). Conversely, spillovers to “riskier” countries, such as Italy and Spain, are smaller and statistically insignificant. This suggests that safe sovereign bonds within the euro area are highly substitutable, and convenience yields are interconnected across countries. 

The paper also develops a two-country model with default risk to rationalise the findings. In the model, convenience yields arise because sovereign bonds can be re-traded at relatively favourable prices even in recessions and therefore provide insurance to individuals against income risk. Because sovereign bonds from either country can provide such insurance service, the prices of both bonds respond to changes in the quantities of either bond by the law of supply and demand. However, bonds from riskier issuers are imperfect substitutes to bonds from "safe" countries: their value doesn’t hold up as well in recessions and therefore they are less useful as an insurance device. Being more imperfect substitutes, riskier sovereign bonds are less affected by spillovers from the issuance of "safe" bonds.

These findings suggest that fiscal policies within the euro area are more interconnected than previously thought, especially among low-risk countries. Debt issuance in one safe country can impact borrowing costs in others, pointing to the need for coordinated fiscal policies to manage these spillover effects. This highlights a new form of fiscal spillover, where the total amount of safe debt matters more than which country issues it. The policy implications are significant, as euro area countries  need to collaborate on fiscal strategies to maintain favourable convenience yields, and ensure that sovereign debt remains sustainable at low interest rates.