New research presents a novel measure of financial fragmentation along national borders for the euro area''s corporate bond market. The study by Andrea Zaghini, to be presented at the Royal Economic Society''s annual conference in Brighton in March 2016, shows that corporations from different euro area countries faced noticeably different costs of funding in the bond market during the prolonged period of financial instability that started in 2007.
The fact that actual prices are different may correctly reflect the different characteristics of the bond and the issuer (perfect market integration). But it may also conceal the investors'' misjudgement and the pricing of unidentifiable country-specific risks (market fragmentation). Thus, a direct comparison of corporate bond premia across countries, while informative per se, does not serve as a good indicator of the market behaviour.
The analysis starts from the very definition of financial integration, which refers to a context in which the price of a bond does not depend on the nationality of the issuer: the well-known law of one price, which implies the perfect market functioning. The author first identifies the fundamental sources of the proper corporate bond pricing and then isolates the residual country-specific effects for 10 euro area countries that are the indicator of market fragmentation.
The empirical evidence suggests that the pricing of bonds was in line with the fundamentals (perfect market integration) in the period before the global financial crisis, but it became highly distorted after September 2007.
In particular, the degree of fragmentation reached a maximum during the sovereign debt crisis when the spread in the funding cost vis-à-vis German corporations became strongly positive. Corporations in Italy faced an increased cost of funding unjustified by fundamentals of over 100 basis points, Ireland and Spain around 200 basis points and Portugal over 400 basis points.
Since different funding cost across countries due to the market misjudgement of the fundamentals has a perverse effect on the monetary policy transmission, in the second half of 2012 the ECB devised a new non-conventional tool named OMT, announced in the ''whatever-it-takes'' speech by President Draghi. In the period after the OMT introduction the estimated spreads declined considerably, but fragmentation disappeared only in the latest period characterised by the expectations and the actual deployment of a structured quantitative easing.
But the low level of estimated market fragmentation at the end of the period is associated with a still significant heterogeneity in actual bond spreads, challenging the consistency of the new equilibrium. A possible explanation is linked to the existence of a further market mispricing of some sources of risk.
In particular, in line with the findings of a recent literature, a possible additional role as an independent source of pricing is found for the sovereign creditworthiness – most likely started in the troubled period of the sovereign debt crisis – which may well take some time in fading out in normal times.
All in all, the evidence in this research hints at a disorderly process of risk assessment over the extended period of the global financial crisis, the great recession and the sovereign debt crisis, which is pushing the euro area corporate bond market towards a new framework, in which a possibly mild degree of fragmentation and a sizable heterogeneity in the actual yields coexist.
A TALE OF FRAGMENTATION: Corporate funding in the euro-area bond market
