Credit Risk Is the Main Driver of Sovereign Yield Spreads in the Euro Area

A new study published by our researcher Marta Gómez-Puig, along with Adrián Fernandez-Perez (University College Dublin) and Simón Sosvilla-Rivero (Universidad Complutense de Madrid) named “Examining the transmission of credit and liquidity risks: A network analysis for EMU sovereign debt markets” offers crucial insights into how credit and liquidity risks interact in the Eurozone’s sovereign debt markets. Using an innovative network analysis, the researchers reveal that credit risk is the main source of contagion, often spilling over into liquidity risk—especially during times of financial stress.

The paper investigates risk transmission mechanisms among nine euro-area countries from 2008 to 2018. The findings challenge the traditional assumption that liquidity shocks drive bond market turbulence, instead showing that rising credit concerns—particularly in fiscally weaker countries like Italy, Spain, and Ireland—tend to trigger broader market disruptions.

The study highlights four key findings:

1. Credit risk is the primary transmitter of risk within and across countries.
2. Germany—despite its central role in the EMU—acts mostly as a risk absorber, particularly in terms of liquidity.
3. The degree of risk transmission varies over time, peaking during crisis periods.
4. During the European sovereign debt crisis, transmission of liquidity risk became dominant, reflecting investors’ preference for easily tradable assets in illiquid markets.

The research employs network connectedness metrics, allowing the authors to map how shocks in one country’s credit or liquidity conditions affect others. Notably, the analysis shows that strong fiscal fundamentals can shield a country from becoming a net transmitter of sovereign risk.

As the EU updates its fiscal framework, the authors argue that strengthening public finances remains critical.

The study underscores the value of EU-level fiscal tools, such as the Recovery and Resilience Facility, in mitigating systemic risks. It also supports the recent 2024 EU fiscal reforms aimed at improving macroeconomic stabilisation and resilience.

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