This paper develops an arbitrage-free affine term structure model of potentially defaultable sovereign bonds to model a … expected default probabilities and thereby spreads towards Germany, assumed to be free of default risk. The pricing factors are … expected changes in debt/GDP ratios of the respective countries. Our model explains spreads both before and during the crisis …

pricing models and of the roles played by the regimes in these models. Both default-free and defaultable bonds are considered …

factors and regimes explain most of the fluctuations in euro-area yields and spreads. The regime-switching feature of the … risk premia that are incorporated in spreads. Once liquidity-pricing effects and risk premia are filtered out of the … spreads, we obtain estimates of the actual –or real-world– default probabilities. The latter turn out to be significantly …