As soon as the European Monetary Union (EMU) took place in 1999, an integrated market for fixed-income securities came to life in the Euro-area. EMU eliminated currency risk within this area, and standardization of bond conventions by Euro-area sovereign issuers made public bonds more easily comparable.
As a result, the public debt securities issued by different Euroarea governments became very close substitutes: yield spreads on Euro-area government bonds converged significantly, narrowing from highs in excess of 300 basis points, for certain maturities, to less than 30 basis points across the maturity spectrum over the course of 1997-98.
Yet, despite such convergence, euro-zone government bonds are still not regarded as perfect substitutes by market participants: non-negligible differences in yield levels across countries have remained, to different extents for different issuers and maturities, and they fluctuate over time without a clearly discernible trend. For some reason even the bonds issued by the highest-rated issuers are not regarded as perfect substitutes of each other, so that for example French bonds traded in the cash market are not considered as a perfect hedge for positions in Bund futures.
What is the reason for these persistent differentials? One possible explanations is persistent risk differences. Different sovereign issuers are perceived as featuring different solvency risks, in spite of the provisions of the Stability Pact. A second possible explanation is liquidity. This is indeed the explanation that often the financial press gives for these yield differentials. But a simple look at the time-series behavior of Euro-area yield differentials suggests that neither one of these two factors in isolation is likely to provide the full answer.