Sovereign credit spreads

The paper develops a structural credit risk model to study sovereign credit risk and the dynamics of sovereign credit spreads. The model features endogenous default and recovery rates that both depend on the interaction between domestic output fluctuations and global macroeconomic conditions. We show that sovereigns choose to default at higher levels of economic output once global macroeconomic conditions are bad. This yields to default rates and credit spreads that are substantially higher compared to normal times. We derive closed-form expressions for sovereign debt values and default times and focus on the dynamics of sovereign credit spreads. As opposed to standard theories of sovereign debt, this paper’s structural model generates much richer default patterns and non-linearities through regime-shifts in the global macroeconomic environment. Moreover, changes in the global environment reveal the interconnectedness of the financial system.     

Information uncertainty,information asymmetry and corporate bond yield spreads

This study examines the effects of information uncertainty and information asymmetry on corporate bond yield spreads using American data from 2001 to 2006. Empirical results of this study show that investors charge a significant risk premium for both information uncertainty and information asymmetry when controlling for variables well known in the literature. The results are robust even when controlling for credit ratings. Finally, information uncertainty and asymmetry help structural-form credit models explain the yield spreads of bonds with short maturities.     

Sovereign bond yield spreads: A time-varying coefficient approach

We study the determinants of sovereign bond yield spreads across 10 EMU countries between Q1/1999 and Q1/2010. We apply a semiparametric time-varying coefficient model to identify, to what extent an observed change in the yield spread is due to a shift in macroeconomic fundamentals or due to altering risk pricing. We find that at the beginning of EMU, the government debt level and the general investors’ risk aversion had a significant impact on interest differentials. In the subsequent years, however, financial markets paid less attention to the fiscal position of a country and the safe haven status of Germany diminished in importance. By the end of 2006, two years before the fall of Lehman Brothers, financial markets began to grant Germany safe haven status again. One year later, when financial turmoil began, the market reaction to fiscal loosening increased considerably. The altering in risk pricing over time period confirms the need of time-varying coefficient models in this context.     

Multimarket trading and corporate bond liquidity

Global bonds are international securities traded and settled efficiently in multiple markets. This paper examines global bonds to evaluate the effects of multimarket trading on corporate bond liquidity and pricing. The results show that global bonds are significantly more liquid than similar-sized domestic bonds of the same issuers, and their liquidity advantage is reflected in higher market valuations. These findings support microstructure models that predict a positive relation between the number of potential investors and liquidity in over-the-counter markets, and help explain the increasing use of global bonds by corporate issuers.     

The term structure of sovereign default risk in EMU member countries and its determinants

We analyze the determinants of sovereign default risk of EMU member states using government bond yield spreads as risk indicators. We focus on default risk for different time spans indicated by spreads for different maturities. Using a panel framework we analyze whether there are different drivers of default risk for different maturities. We find that lower economic growth and larger openness increase default risk for all maturities. Higher indebtedness only increases short-term risk, whereas net lending, trade balance and interest rate costs only drive long-term default risk.     

Suppliers’ and customers’ information asymmetry and corporate bond yield spreads

This study investigates the information asymmetry effects of suppliers and customers on a firm’s bond yield spreads by employing American bond market data from 2001 to 2008. This study finds that both suppliers’ and customers’ information asymmetry effects significantly explain a firm’s bond yield spreads. Besides, the information asymmetry effects of more important suppliers and customers are more significant than those of less important ones. The results are robust even after controlling for other well-known firm specific and economic variables.     

Corporate bond credit spreads and forecast dispersion

Recent research establishes a negative relation between stock returns and dispersion of analysts’ earnings forecasts, arguing that asset prices more reflect the views of optimistic investors because of short-sale constraints in equity markets. In this article, we examine whether a similar effect prevails in corporate bond markets. After controlling for common bond-level, firm-level, and macroeconomic variables, we find evidence that bonds of firms with higher dispersion demand significantly higher credit spreads than otherwise similar bonds and that changes in dispersion reliably predict changes in credit spreads. This evidence suggests a limited role of short-sale constraints in our corporate bond data sets. Consistent with a rational explanation, dispersion appears to proxy largely for future cash flow uncertainty in corporate bond markets.     

Internal liquidity risk in corporate bond yield spreads

The recent global financial crisis reveals the important role of internal liquidity risk in corporate credit risk. However, few existing studies investigate its effects on bond yield spreads. Panel data for the period from year 1993 through 2008 show that corporate internal liquidity risk significantly impacts bond yield spreads (and changes) when controlling for well-known bond yield determinant variables, traditional accounting measures of corporate debt servicing ability, cash flow volatility, credit ratings, and state variables. This finding indicates that internal liquidity risk should therefore be incorporated into bond yield spread modeling.     

Determinants of sovereign yield spreads in the Eurozone: A Bayesian approach

We analyze the determinants of sovereign yields spreads of EMU member states applying Bayesian Model Averaging (BMA) to annual panel data from 1999 to 2009. BMA is well-suited in cases of small samples and high model uncertainty. This seems to be the case in modeling sovereign yield spreads in the Eurozone since the literature reports heterogeneous results with respect to significant explanatory variables. We are testing a number of variables reported to be significant in the literature and find that the most likely country specific drivers of yield spreads are fiscal variables such as budget balance and government debt, as well as external sector variables, such as terms of trade, trade balance and openness. Global financing conditions, indicated by the US interest rate, and market sentiments, indicated by corporate bond spreads, are likely to influence sovereign yield spreads.     

Internal liquidity risk,financial bullwhip effects,and corporate bond yield spreads: Supply chain perspectives

This study explores internal liquidity risk (ILR) and financial bullwhip effects on corporate bond yield spreads along supply chain counterparties by employing American market data from year 1997 to 2008. This study finds that the ILRs of suppliers and customers positively affect a firm’s bond yield spreads and the effects of customers’ ILRs are greater. This research also finds a financial bullwhip effect that the ILR effect becomes greater upwardly along the supply chain counterparties. The results are robust when controlling for well-known spread determinant variables.     

Regime dependent determinants of credit default swap spreads

Credit default swap (CDS) spreads display pronounced regime specific behaviour. A Markov switching model of the determinants of changes in the iTraxx Europe indices demonstrates that they are extremely sensitive to stock volatility during periods of CDS market turbulence. But in ordinary market circumstances CDS spreads are more sensitive to stock returns than they are to stock volatility. Equity hedge ratios are three or four times larger during the turbulent period, which explains why previous research on single-regime models finds stock positions to be ineffective hedges for default swaps. Interest rate movements do not affect the financial sector iTraxx indices and they only have a significant effect on the other indices when the spreads are not excessively volatile. Raising interest rates may decrease the probability of credit spreads entering a volatile period.     

Varying risk premia in international bond markets

Cochrane and Piazzesi [Cochrane, J.H., Piazzesi, M., 2005. Bond risk premia. American Economic Review 95, 138–160] use forward rates to forecast future bond returns. We extend their approach by applying their model to international bond markets. Our results indicate that the unrestricted Cochrane and Piazzesi (2005) model has a reasonable forecasting power for future bond returns. The restricted model, however, does not perform as well on an international level. Furthermore, we cannot confirm the systematic tent shape of the estimated parameters found by Cochrane and Piazzesi (2005). The forecasting models are used to implement various trading strategies. These strategies exhibit high information ratios when implemented in individual countries or on an international level and outperform alternative approaches. We introduce an alternative specification to forecast future bond returns and achieve superior risk-adjusted returns in our trading strategy. Bayesian model averaging is used to enhance the performance of the proposed trading strategy.     

The determinants of recovery rates in the US corporate bond market

We examine recovery rates of defaulted bonds in the US corporate bond market, based on a complete set of traded prices and volumes. A study of the trading microstructure around various types of default events is provided. We document temporary price pressure with high trading volumes on the default day and the following 30 days, and low trading activity thereafter. Based on this analysis, we determine market-based recovery rates and quantify various liquidity measures. We study the relation between the recovery rates and these measures, considering additionally a comprehensive set of bond characteristics, firm fundamentals, and macroeconomic variables.     

The reaction of emerging market credit default swap spreads to sovereign credit rating changes

This paper examines the effect of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies’ CDS premiums. We find that positive events have a greater impact on CDS markets in the two-day period surrounding the event, and are more likely to spill over to other emerging countries. Alternatively, CDS markets anticipate negative events, and previous changes in CDS premiums can be used to estimate the probability of a negative credit event. The transmission mechanisms for positive events are the common creditor and competition in trade markets.     

A compound option approach to model the interrelation between banking crises and country defaults: The case of Hungary 2008

We analyze the Hungarian financial crisis of 2008 in a stochastic framework that advances structural credit risk models for country defaults: by applying compound option theory we consider payments for bailing-out the banking sector together with debt service payments in a joint crisis model. We estimate the model parameters by applying the time series maximum-likelihood approach of Duan (1994) on yield spreads of Hungarian Bonds. We find that difficulties in acquiring funds for debt servicing in combination with high outstanding debt triggered the crisis, rather than problems in the domestic banking sector. The estimated crisis probabilities dramatically rise during 2008.     

The economic determinants of interest rate option smiles

We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.     

Is it punishment? Sovereign defaults and the decline in trade

Sovereign defaults are associated with declines in defaulting countries trade. Are these declines the result of trade sanctions as the trade sanctions argument of sovereign borrowing would suggest? We devise an empirical strategy to evaluate this issue based on the idea that if trade sanctions are causing the declines, bilateral trade with creditor countries should fall more than trade with other countries. We find that this is not the case. The analysis does not yield much evidence of broader punishment strategies including a league of major creditors either. These results contradict the predictions of the trade sanctions theory of sovereign borrowing.     

Sovereign debt disputes: A database on government coerciveness during debt crises

This paper measures “debt disputes” between governments and foreign private creditors in periods of sovereign debt crises. We construct an index of government coerciveness, consisting of 9 objective sub-indicators. Each of these sub-indicators captures unilateral government actions imposed on foreign banks and bondholders. The results provide the first systematic account of debt crises that goes beyond a binary categorization of default versus non-default. Overall, government behavior and rhetoric show a strong variability, ranging from highly confrontational to very smooth crisis resolution processes. In a preliminary analysis on the determinants of coercive behavior, we find political institutions to be significant, while economic and financial factors play a lesser role. These results open up an agenda for future research.     

Risky public domestic debt composition in emerging economies

This paper explains why public domestic debt composition in emerging economies can be risky, namely in foreign currency, with a short maturity or indexed. It analyses empirically the determinants of these risk sources separately, developing a new large dataset compiled from national sources for 33 emerging economies over 1994–2006. The paper finds that economic size, the breadth of the domestic investor base, inflation and fiscal soundness are all associated with risky public domestic debt compositions, yet to an extent that varies considerably in terms of magnitude and significance across sources of risk. Only inflation impacts all types of risky debt, underscoring the overarching importance of monetary credibility to make domestic debt compositions in emerging economies safer. Given local bond markets' rapid development, monitoring risky public domestic debt compositions in emerging economies becomes increasingly relevant to global financial stability.