We introduce Longitudinal Factor Analysis (LFA) to extract the Common Risk Free (CRF) rate from a sample of sovereign bonds of countries in a monetary union. Since LFA exploits the typically very large longitudinal dimension of bond data, it performs better than traditional factor analysis methods that rely on the much smaller cross-sectional dimension. European sovereign bond yields for the period 2006-2010 are decomposed into a CRF rate, a default risk premium, and a liquidity risk premium, shedding new light on issues such as benchmark status, flight-to-quality and flight-to-liquidity hypotheses. Our empirical findings suggest that investors chase both credit quality and liquidity, and that liquidity is more valued when aggregate risk is high.
factor analysis risk free interest rate sovereign bond benchmark