Euro area sovereign bond risk premia before and during the Covid-19 pandemic

We provide a novel modeling framework to decompose euro area sovereign bond yields into five distinct components: (i) expected future short-term risk-free rates and a term premium, (ii) a default risk premium, (iii) redenomination risk premium, (iv) liquidity risk premium, and (v) segmentation (convenience) premium. Identification is achieved by considering sovereign yields jointly with other rates, including sovereign credit default swap spreads with and without redenomination as a credit event trigger. We illustrate our model by studying yield components embedded in German, French, Italian, and Spanish sovereign bonds, before and after the onset of the Covid-19 pandemic in 2020, and by examining the impact of European Central Bank (ECB) monetary policy and European Union (EU) fiscal policy announcements in response to the pandemic. We find that all five risk premia became sizable following the onset of the pandemic, and that both monetary and fiscal policy announcements had a pronounced effect on yields, mostly through default, redenomination, and segmentation (convenience) premia.