Sovereign Risk and the Referendum – How Have Bonds Responded?

Abstract:

As the debate around the UK’s impending referendum on EU membership has ebbed and flowed, so too have financial markets. Using our newly developed estimates for sovereign risk premia, we uncover how news about the likely outcome of the referendum has impacted financial markets, and what this might tell us about the determinants of sovereign term premia and investors’ attitudes to risk. We find that increases in the probability of an exit from the EU are associated with a reduction in UK term premia and falls in UK stock prices. Moreover, we find evidence of spillover effects to the Euro Area; specifically periphery term premia are increasing, and German term premia are decreasing, in the likelihood of the UK voting to leave the EU. These patterns are consistent with the view that in the run up to the referendum changes in investors’ risk aversion have been a significant determinant of sovereign bond premia. Increases in the probability of a vote to leave are associated with investors rebalancing their portfolios away from risky assets and into safer assets, including UK government bonds.

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