Common Sovereign Debt Instruments: An Analytical Framework

This paper presents a novel, integrated framework for the financial assessment of different types of common sovereign debt instruments in a currency union such as the euro area and provides results for their key credit risk properties at Member State and euro area level. The options under assessment include instruments involving full and partial mutualisation of sovereign risk, as well as instruments based on the pooling and tranching of national government debt without mutualisation. The results show that full risk mutualisation can lower financing costs for all participating countries, and that “eurobonds” would have weathered well the European sovereign debt crisis, even if partial mutualisation remains the most attractive option for the more creditworthy countries. Options involving just the tranching and pooling of Member State debt simply reallocate sovereign risk across instruments, although the “E-bonds” proposal can approximate the characteristics of mutualised “blue bonds” under certain conditions. The analytical framework can also be applied to assess the strength of sovereign risk interlinkages, the evolution of sovereign debt capacity over time and its decomposition into systemic and idiosyncratic factors.