Tag Archives: Sovereign risk

“Sovereign Bond Prices, Haircuts, and Maturity,” NBER, 2017

NBER Working Paper 23864, September 2017, with Tamon Asonuma and Romain Ranciere. PDF. (Local copy.)

Rejecting a common assumption in the sovereign debt literature, we document that creditor losses (“haircuts”) during sovereign restructuring episodes are asymmetric across debt instruments. We code a comprehensive dataset on instrument-specific haircuts for 28 debt restructurings with private creditors in 1999–2015 and find that haircuts on shorter-term debt are larger than those on debt of longer maturity. In a standard asset pricing model, we show that increasing short-run default risk in the run-up to a restructuring episode can explain the stylized fact. The data confirms the predicted relation between perceived default risk, bond prices, and haircuts by maturity.

“Sovereign Bond Prices, Haircuts, and Maturity,” CEPR, 2017

CEPR Discussion Paper 12252, August 2017, with Tamon Asonuma and Romain Ranciere. PDF. (ungated IMF WP.)

Rejecting a common assumption in the sovereign debt literature, we document that creditor losses (“haircuts”) during sovereign restructuring episodes are asymmetric across debt instruments. We code a comprehensive dataset on instrument-specific haircuts for 28 debt restructurings with private creditors in 1999–2015 and find that haircuts on shorter-term debt are larger than those on debt of longer maturity. In a standard asset pricing model, we show that increasing short-run default risk in the run-up to a restructuring episode can explain the stylized fact. The data confirms the predicted relation between perceived default risk, bond prices, and haircuts by maturity.

“Sovereign Bond Prices, Haircuts, and Maturity,” IMF, 2017

IMF Working Paper 17/119, May 2017, with Tamon Asonuma and Romain Ranciere. PDF.

Rejecting a common assumption in the sovereign debt literature, we document that creditor losses (“haircuts”) during sovereign restructuring episodes are asymmetric across debt instruments. We code a comprehensive dataset on instrument-specific haircuts for 28 debt restructurings with private creditors in 1999–2015 and find that haircuts on shorter-term debt are larger than those on debt of longer maturity. In a standard asset pricing model, we show that increasing short-run default risk in the run-up to a restructuring episode can explain the stylized fact. The data confirms the predicted relation between perceived default risk, bond prices, and haircuts by maturity.

Currency Denomination Risk in the Euro Area

In the FT (Alphaville), Marcello Minnena explains what type of currency denominations of Euro area sovereign debt constitute credit events; and how markets assess the risk of such denominations.

After the Greek default in 2012

new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies [unless the debt is redenominated] into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”.

Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) has generally been small: 15-20 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany.

Since January 2017, the spread difference for Italy and France has increased by roughly 20 basis points.

Re-Denomination Risk in France and Italy

On the FT Alphaville blog, Mark Weidemaier and Mitu Gulati argue that re-denomination risk in the Euro zone is most prominent in France and Italy. Bonds with CACs trade at higher prices.

Most French and Italian [but not Greek] debt is governed by local law. … the governments could pass legislation redenominating their bonds from euros to francs or lira.

… [But] some French and Italian bonds — bonds issued after January 1, 2013, with maturities over a year — have Collective Action Clauses (CACs). … Importantly, these CACs require a super-majority of investors (in principal amount) to approve any changes to the currency of the bond.

… But it’s also possible a local law bond is no different than a local law bond with a CAC. After all, both are ultimately subject to the whims of the local legislature, and the courts may side with them.

The markets seem to have a view, though: CAC bonds in the countries with heightened redenomination risk seem to be valued significantly more.

Credit Default Swaps

In a set of slides from Deutsche Bank Research (from 2011), Kevin Körner discusses credit default swaps and the sovereign default probabilities implied by these swaps.

The CDS spread amounts to the insurance premium a protection buyer pays to the protection seller; it is quoted in basis points per year of the underlying security’s notional amount; and it is paid quarterly. In the event of a default on the underlying security, the protection seller effectively must pay one minus the recovery rate on the security (the protection seller pays the notional amount and receives the security).

Example: A CDS spread of 339 bp for five-year Italian debt means that default insurance for a notional amount of EUR 1 m costs EUR 33,900 per annum; this premium is paid quarterly (i.e. EUR 8,475 per quarter).

“In equilibrium,” the present discounted value of premium payments (up to the maturity of the underlying security) corresponds with the present discounted compensation payments by the protection seller (up to maturity).

Current data.

Why Do Sovereigns Repay External Debt?

In a Vox blog post (that complements another post on Greece), Jeremy Bulow and Ken Rogoff review the academic discussion on a long-standing question—why sovereigns repay their external debt.

Bulow and Rogoff distinguish between

[t]he ‘reputation approach’ pioneered by Eaton and Gersovitz (1981) which builds on Hellwig (1977);
and the ‘direct punishments’ bargaining-theoretic approach of Bulow and Rogoff (1988b, 1989a) which in turn builds on Cohen and Sachs (1986).

They argue that the latter approach—attributing enforceable rights in foreign country courts to creditors—better explains observed outcomes.

[The] direct punishment/bargaining approach lends itself very naturally to incorporating moral hazard; …
reputation models suggest [counter factually] that the governing law of the debt is irrelevant;
[i]n standard reputation for repayment models, write-downs are decided unilaterally—creditors’ particular concerns do not really matter; …
[t]he interests and welfare of unrelated third parties does not matter in standard reputation models; …
[r]eputational debtors borrow in bad times and re-pay in good times, for purposes of income smoothing; [d]efaults, if they are to take place, occur in good times … In reality, many countries borrow as much as they can whenever they can. … Debt crises occur when countries do badly and creditors decide they want to reduce their loan exposure. To some extent, this issue can be addressed by assuming that income shocks are permanent and not transitory, but it remains difficult to rationalise country borrowing only on the threat of lost consumption smoothing. …
[c]reditor identity doesn’t matter; …
[u]nder … general assumptions, the existence of [the option to put savings abroad] leads to the unravelling of any purely reputational equilibrium.

Bulow and Rogoff add that

[a]nother important issue … is that in practice, sovereign debt renegotiations focus very much on the flow of repayments, and much less on how the stock of debt evolves. This is precisely because all sides realise that any future promises can be renegotiated.

“Debt-Maturity without Commitment,” CEPR, 2008

CEPR Discussion Paper 7093, December 2008. PDF.

We analyze how sovereign risk paired with social costs of default shapes the maturity structure of public debt. A government without commitment power balances benefits of default, due to tax savings, and costs, due to output losses. Debt issuance affects subsequent default and rollover decisions and thus, current debt prices. This induces welfare costs beyond the consumption smoothing benefits from the marginal unit of debt. The equilibrium choice of short- versus long-term debt issuance minimizes these welfare costs. Consistent with empirical evidence, closed-form solutions of the model predict an interior maturity structure with positive gross positions and a shortening of the maturity structure during times of crisis and low output. In simulations, the model replicates additional features of the data.