Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt*

Abstract

This paper investigates the effects of macroeconomic fundamentals on emerging market sovereign credit spreads. We find that the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. This is robust to instrumenting terms of trade with a countryspecific commodity price index. Our measures of country fundamentals have substantial explanatory power, even controlling for global factors and credit ratings. We also estimate default probabilities in a hazard model and find that model implied spreads capture a significant part of the variation in observed spreads out-of-sample. The fit is better for lower credit quality borrowers.JEL classifications: F34, G12, G13, G15

Sovereign credit risk dynamics in the European Monetary Union (EMU)

“…Concerning the international risk factors, equity volatility proxied by the VIX index has statistically significant influence on yield spreads which confirm previously reported results by Hilscher and Nosbusch (2010) and Klepsch (2011). In addition, TED spread and USCS corporate yield spread are nonsignificant.…”

“…9 A similar relationship has also been reported for corporate spreads by Campbell and Taksler (2003). Hilscher and Nosbusch (2010), using data for 31 emerging countries during the 1994 to 2007, find evidence that the longer the period since last default, the lower is the sovereign credit spread. Cantor and Packer (1996) suggest the exclusion of credit rating from the model when other credit-related variables are included.…”

“…Concerning the debt service ratio, 7 the reported evidence is mixed. Barrios et al (2009) report its significance for the seven EMU countries in the sample for the period 2003 to 2009, 1 For a related literature review on the study of corporate credit spreads, see Manzoni (2002), and for emerging markets sovereign credit spreads see Hilscher and Nosbusch (2010 Geyer et al (2004) and Favero et al (2010) also suggest the use of French OATs as a benchmark for the short maturities in the EMU bond market. 3 For example, , using a simple mean-variance model where investors aim to maximize utility, decompose yield spreads between a domestic and a foreign risk-free government bonds into the (a) the default risk premium, (b) the liquidity premium and (c) the country-specific risk premium that depends negatively on the percentage of the gross payment in case of default, positively with the variance of the default probability of the domestic issuer, the gross nominal return and the level of relative risk aversion of domestic and foreign investor.…”

Excessive Debt or Excess Savings -- Transition Countries Sovereign Bond Spread Assessment

“…More importantly, the impact of this global risk variable is not constant over time, a clear sign of contagion driven by shifts in market." Hilscher and Nosbusch (2010), investigate spread determinants by focusing on the volatility of fundamentals. They observe " [t]hat the volatility of the terms of trade is both statistically and economically significant in explaining spread variation.…”

Sovereign credit ratings, growth volatility and the global financial crisis

“…To explain sovereign credit ratings, our choice of control variables has been guided by the literature on the fundamental economic determinants of country risk and sovereign default risk (Cantor and Packer, 1996;Hilscher and Nosbusch, 2010) indicating that macroeconomic variables like inflation (INF, VINF), GDP (LGDP and GROWTH) and interest rates (MONEY) are important determinants as deteriorations in a country's macroeconomic conditions will severely affect the government's ability to repay its debts. We also include a composite risk measure (COMPRISK) sourced from the ICRG as it incorporates aspects of financial, economic and political risks within countries and has been documented to be important for growth opportunities by Bekaert et al (2007).…”