Highlights:

• Markets’ pricing of the risk premium on sovereign issuers is volatile and subject to various drivers. Splitting the contribution of macro and fiscal fundamentals from that of volatile market perceptions can help find profitable buying and selling opportunities. We develop a framework to estimate the fair value of government bond spreads for Italy, France, and Spain. The estimate is based on fiscal and macroeconomic fundamentals only. 

• The model suggests that the BTP spread is currently close to fair value, as the negative perception of the country has abated. The rise in the OAT spread is tracking deteriorating fundamentals. 

• The model also allows to identify the drivers of the spread evolution. e.g., to quantify how much of the compression of Italian and Spanish spreads is due to the reduction in debt/GDP and lower unemployment after the pandemics. 

• Ownership structures also matters. Italian BTPs have traditionally been held by domestic investors and the ECB's purchases have mainly replaced foreign investors. OATs’ share of foreign investors has recently risen to over 50% as the ECB has gradually withdrawn amid its Quantitative Tightening (QT). 

• Not just spread levels, but also spread volatility matters for investors. While the volatility of the OAT/Bund spread has traditionally been significantly lower than that of the BTP/Bund and Bono/Bund spreads, they have recently moved noticeably closer together. A methodology derived from volatility to assess market participants' preferences shows that risk aversion towards OATs is at a very high level, in contrast to BTPs and Bonos. 

• In general, both volatility and yields have fallen across all maturities over the past year. Short-term Spanish Bonos currently offer a very good risk-adjusted yield, which even exceeds that of German Bunds on both counts. 

• Finally, we show that even simple systematic investment strategies based on macroeconomically derived fair values can generate excess returns, without increasing volatility.

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