The ECB and the TPI: How to Measure the Fragmentation Risk in the Eurozone Sovereign Bond Market

Since the sovereign debt crisis, the Eurozone has suffered from, among others, the problem of high fragmentation of the sovereign debt market, with the effect of a widening of spreads not always justified by fundamentals, but rather often amplified by fluctuations in market sentiment.

To address this problem, the ECB launched several programmes, notably the PSPP and PEPP. Both were designed and implemented in an environment of low interest rates and low inflation.

With rising inflation and the need to curb it, the ECB launched the Transmission Protection Facility (ECB 2022a).

The TPI is de facto a commitment of the ECB to intervene in markets to curb yields deemed to be “excessive”, in the sense that they are not justified by the fundamentals or by countries’ fiscal profligacy.

A weakness of the TPI as a policy instrument, however, is its lack of precision in determining which yields are justified and which are not. This risks creating arbitrariness and difficulties in providing markets with forward guidance.

How to measure “excessiveness”

In our proposal for a European Debt Agency (EDA) (Amato et al. 2021, 2002 2023), we developed a pricing mechanism to calculate an 'idiomatic price' for each Member State (MS). The idiomatic price is calibrated to the specific creditworthiness and probability of default (PD) of each MS.

In the institutional framework of the EDA, the idiomatic price would be the price at which the EDA would grant perpetual loans to MS, thus avoiding any form of mutualization.

This is where our proposed instrument comes in: we use the pricing mechanism of perpetual loans by our proposed European Debt Agency to determine a dynamic yield corridor that captures idiosyncratic risk and filters liquidity risk.

To price the irredeemable mortgage scheme EDA computes the present value of an infinite stream of payments using as a discount rate the yield that reflects its cost of debt, which is proxied by the euro area 10-year fixed interest rate on swaps. Future payments are not deterministic, but they occur only if MSs are not in “default". The probability with which a given MS enters the state of default in each future period is computed by

1. assigning each MS to a specific credit risk class j based on its creditworthiness, from the safest (conventionally labelled AAA) to the default class (labelled D)
2. assuming that a country defaults only when it reaches state D, and modelling the transition from one state to the other via a transition matrix estimated averaging publicly available data of rating grades assigned to sovereign debts by Credit Rating Agencies in the period 1993-2015 (Standard & Poor's Sovereigns Ratings have been downloaded from Bloomberg)

Given the discount factor and the credit risk migration model, the present value of a unitary perpetual annuity for a country i initially in credit risk class j can be then computed as ai,j and the interest on the perpetual annuity is then set to its reciprocal 1/ ai,j (see the technical appendix for a detailed derivation and description).

The interest rate on the perpetual annuity is the benchmark that we offer to evaluate fluctuations in the yields of 10-year government bonds. As this varies with creditworthiness, we report for each country bounds represented by the interest rates of the classes just above and just below in terms of creditworthiness.

A Monitoring Tool for Institutions and Policymakers

As suggested in (Amato et al 2023), the EDA’s pricing scheme could be adopted by the ECB to provide a transparent algorithm to determine deviations from fundamentals.

This would be a transparent method to justify intervention, which would happen only when the upper/lower bound is approached, leaving market forces to determine prices as they fluctuate within the bands, whilst “morally persuading” them not to cross the thresholds. In other words, the instrument may be so preemptive that it cannot actually be used.

The policy proposal remains, but in the meantime, the tool can be used to monitor the state of market sentiment.

The algorithm is compiled and updated with daily data for each MS, and can also be consulted over longer periods to monitor trends.

IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.

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