Description:
In the years leading up to the pandemic, the yield spread between Danish and German sovereign bonds was roughly zero across maturities. In March 2020, the spreads widened and have stayed positive since. This memo investigates the drivers of the 10-year yield spread, which has widened 25 basis points from January 2020 to March 2022. The widening is found to be driven mainly by a larger term premium spread. We propose two explanations behind this related to financial frictions. First, the ECB's significant bond purchases during the pandemic has increased collateral scarcity of German sovereign bonds. Second, duration on callable Danish mortgage bonds have increased substantially, possibly lowering demand for Danish sovereign bonds. Empirically, collateral scarcity of German sovereign bonds and duration on Danish mortgage bonds are found to have widened the 10-year yield spread by 9 and 5 basis points, respectively, from January 2020 to March 2022. Differences in liquidity is found to be an important factor as well.