Does political instability matter for sovereign yield spreads in the Euro area market ?

The 2008/2009 global financial crisis had a major impact on the European government bond market. At the dawn of the crisis, after a decade of intra-European integration efforts, yields on sovereign bonds issued by countries from the European Monetary Union (EMU) reached a historical low. This achievement was rapidly annihilated by the deterioration of global market conditions since the collapse of Lehman Brothers in October 2008 and the subsequent reassessment of the creditworthiness of selected Eurozone countries by investors. The current paper investigates the main drivers of sovereign yield spreads of EMU countries with respect to German bonds using quarterly data over the 2002-2017 period, and extends the analysis to include the role of political (in)stability. We employ mainly a dynamic panel method, the pooled mean group estimator of Pesaran, Shin and Smith (1999). Our results reveal that, in addition to fundamentals (GDP growth, large public debt, liquidity, market sentiments, and trade deficit), political risks also put substantial upward pressure on sovereign bond yields.