Effects of Sovereign Risk on Duration: Evidence from European and Latin American Sovereign Bond Markets

51 Pages Posted: 2 Sep 2012

See all articles by Hei Wai Lee

Hei Wai Lee

University of Michigan at Dearborn - School of Management

Yan Alice Xie

University of Michigan at Dearborn

Jot Yau

Seattle University

Date Written: August 30, 2012

Abstract

We examine effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996-2011. We compare the sovereign risk-adjusted duration for U.S. dollar-denominated sovereign bonds with their Macaulay duration for both investment- and speculative-grade bonds. We find that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all bonds, regardless of the bond rating and maturity. Further, the “shortening” effect of sovereign risk on duration is generally stronger among bonds of lower ratings. During the recent global financial crisis, the “shortening” effect was dampened for quality sovereign bonds. But the sovereign risk effect on duration was intensified for BBB and BB rated bonds, reflecting investors’ perception of increasing likelihood of default by issuing nations. Results are robust when CDS prices are used as a proxy for changes in sovereign risk. Moreover, the regional analysis shows that sovereign risk shortens duration much less for sovereign bonds issued by the EU and Latin American countries than for non-EU member counterparts. Our study demonstrates the importance of, and provides a practical guide for, bond portfolio managers to account for sovereign risk in managing interest rate risk exposure in their investments.

Keywords: Sovereign risk, Duration; Sovereign yield spreads, European and Latin American sovereign bonds, Global financial crisis

JEL Classification: G12, G15

Suggested Citation

Lee, Hei Wai and Xie, Yan and Yau, Jot, Effects of Sovereign Risk on Duration: Evidence from European and Latin American Sovereign Bond Markets (August 30, 2012). Available at SSRN: https://ssrn.com/abstract=2139752 or http://dx.doi.org/10.2139/ssrn.2139752

Hei Wai Lee

University of Michigan at Dearborn - School of Management ( email )

4901 Evergreen Road
Dearborn, MI 48128-1491
United States
313-593-5524 (Phone)
313-593-5636 (Fax)

Yan Xie (Contact Author)

University of Michigan at Dearborn ( email )

Dearborn, MI
United States

Jot Yau

Seattle University ( email )

901 12th Avenue
Seattle, WA 98122
United States

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