European spreads at the interest rate lower bound

This paper analyzes the effect of the interest rate lower bound on long-term sovereign bond spreads in the euro area. We specify a joint shadow rate term structure model for the risk-free, the German, and the Italian sovereign yield curves. In our model, the behavior of long-term spreads becomes strongly nonlinear in the underlying factors when interest rates are close to the lower bound, which occurs in the data since the beginning of 2012. We fit the model via Quasi-Maximum Likelihood and show three consequences of the nonlinear behavior of sovereign spreads: (i) they are asymmetrically distributed, (ii) they are affected by (possibly exogenous) changes in the lower bound, and (iii) they become less informative about sovereign risk than when interest rates are far from the lower bound. Shadow spreads, however, still provide reliable information.