The equity-like behaviour of sovereign bonds

Using a rich dataset of high frequency historical information from 2004 to 2013 we study the determinants of European sovereign bond returns over calm and crisis periods. We find that the sign of the equity beta crucially depends on country risk. In low risk countries, government bonds represent a natural hedge against equity risk as the equity beta is negative regardless of market conditions. On the other hand, government bonds of high risk countries lose their “safe-asset” status and exhibit more equity-like behaviour during the sovereign debt crisis, with positive and strongly significant co-movements relative to the stock market. Our estimates indicate that the equity beta switches from negative to positive when a sovereign’s credit spread rises above 2%. We find that the decoupling of the government bond market between high risk and low risk countries implies that indiscriminate portfolio diversification does not pay. Instead, “prudent diversification” appears to offer superior risk adjusted returns in periods of sovereign stress and through the economic cycle.