Explaining yield spreads of Swiss canton bonds: An empirical investigation

Swiss Society for Financial Market Research (pp. 208218)

DOMINIQUE KTTEL AND PETER KUGLER

EXPLAINING YIELD SPREADS OF SWISS CANTON BONDS:AN EMPIRICAL INVESTIGATION WER TRGT DIE SCHULD?

Dominique Kttel ([email protected]), UBS Private Banking, Portfolio Engineering, Zurich. Peter Kugler ([email protected]),Department of Economics, University of Basle, Basle.

The authors wish to thank the referees for their comments.

1. Introduction

We observe a rather large yield differential for the debt of Swiss cantons traded actively in the market. A casual look at the data reveals that non-German cantons (hereinafter called Latin cantons) offer higher yields than German-speaking ones. The cause of these differences is obviously interesting to both holders and issuers of canton government bonds. In light of this interest, the following paper aims at explaining these differences by analyzing empirically the yields of canton bonds issued from 1990 to 1998.

Of course such differences may be spurious as they could be due to differences in maturity or to whether bonds are callable or not. Yet the spreads are sometimes rather large for bonds with quite similar characteristics. Hence these technical aspects do not provide a promising framework for the explanation of the observed yield differences, although they of course have to be accounted for in order to analyze the yield differences properly. Another problem

consists of the fact that the level of interest rates on bonds is subject to considerable business cycle variation. Accordingly we cannot simply compare the interest rates of canton bonds over time and across cantons directly. A natural way to correct yields for the characteristics of the bonds and business cycle variation consists of calculating yield spreads vis vis a federal bonds with the same characteristics using an estimate of the term structure of federal bonds. Our analysis focuses on the explanation of such yield spreads by economic fundamentals and institutional factors.

From the viewpoint of economic theory[1] we would expect a risk premium of canton bonds over federal bonds since the latter carry only an inflation risk, whereas the former have an additional default risk, given that the federal government does not explicitly guarantee canton debt. In addition we would expect yield differences among bonds to reflect differing expectations on the future stance of cantonal fiscal policy. The fiscal prospect of a...