Decomposing the term structures of local currency sovereign bond yields and sovereign credit default swap spreads

In this study, we analyze the relationship between the term structures of local currency-denominated sovereign bond yields and foreign currency-denominated sovereign credit default swap (CDS) spreads for developed countries. We develop a consistent pricing model between the term structures of local currency-denominated sovereign bond yields and foreign currency-denominated sovereign CDS spreads, which allows us to decompose these term structures into credit risk and non-credit risk (e.g., convenience yield or liquidity risk). In the euro area countries, we show that the credit risk components are mainly related to local equity markets or the proxy of the regulatory incentive of the global dealer banks. In the core countries of the euro area, the non-credit risk component of the bond spread is related to the proxy of the flight to liquidity at all maturities, and function as convenience yield. During the sovereign debt crisis in the developed European market, in the peripheral countries of the euro area, the non-credit risk component of the bond spread is related to the liquidity risk. At the short end of the term structure, this relation is stronger than that at longer maturity. On the other hand, the relationships between the non-credit risk components of CDS spreads and risk factors are weak and the fluctuations of the CDS spread is mainly driven by the credit risk components in both country groups.