German government bonds lose their benchmark status
Peter Dunne (Middlesex University Business School),
Michael J Moore (Queen's University, Belfast) and
Richard Portes (London Business School and CEPR)
DP3490 Defining Benchmark Status: An Application using Euro-Area Bonds
August 2002
The introduction of the euro on 1 January 1999 created the conditions for an integrated government bond market in the euro area. As a result, the euro area bond market is now comparable to the US treasuries market in terms of size and issuance volume. Unlike the US, public debt management in the euro area is the responsibility of 12 separate national agencies.
Using a unique data set from the electronic trading platform Euro-MTS, the authors of CEPR Discussion Paper 3490 consider what is the 'benchmark' in this market. The study begins its analysis by defining what it means to be the benchmark in European government debt markets. The most common view associates the benchmark with the lowest yield and other securities are then priced against this. By this definition, the German market would provide the benchmark at all maturities. A plausible alternative is to interpret benchmark to mean the most liquid security, which is therefore most capable of providing a reference point for the market. But the Italian market, not the German, is easily the most liquid for short-dated bonds; the French is most liquid at medium maturities. Dunne, Moore and Portes take the perspective that the benchmark bond is the instrument to which the prices of other bonds react. This approach to defining benchmark status focuses directly on price discovery and regards the price discovery process as a purely empirical matter.
The authors find that the prices of euro area government bonds do not react to any single bond and that any benchmark security should be made from a basket of bonds from different countries. The concept of a benchmark made up of different bonds has been discussed before and dismissed as unworkable due to technical differences between different issues. But the authors point out that market participants are not always fully aware of the structure of their behaviour. Also, this market is changing rapidly, so that both perceptions and analysis may not yet have assimilated fully the new conditions in the market after early 2000.
This study suggests that German securities do not deserve the benchmark status that would come from a focus on securities with lowest yield at a given maturity. Instead, a benchmark portfolio of different government bonds is now more appropriate in the new and only partially integrated market of euro area government bonds. Clearly, more work is needed, but the authors believe that it is clear from their research that at least in the euro area no simple definition of benchmark status will do.
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