Political Risk and Expected Government Bond Returns

Abstract

Political risk relates to both the ability and the willingness of governments to repay debts. We find that bond prices only slowly adapt to changes in political risk. The expected bond returns for countries whose political risk ratings have improved are higher than those for countries whose political risk ratings have deteriorated. This change in political risk premium cannot be explained by the risk factors default premium, term premium, and liquidity, or by momentum, changes in credit ratings, economic risk or financial risk. The risk-adjusted performance is 7.6% per annum for emerging bond markets and 0.8% per annum for euro government bonds.

Keywords: political risk, government bond debt, credit rating, emerging debt

JEL Classification: F37, G14, G17, G28, G38