The Term Structure of CDS Spreads and Sovereign Credit Risk

61 Pages Posted: 8 Nov 2012 Last revised: 28 May 2018

See all articles by Patrick Augustin

Patrick Augustin

McGill University, Desautels Faculty of Management

Date Written: October 31, 2012


I study the term structure of credit default swap spreads to understand the dynamics of global and country-specific risk factors in explaining the time-variation in sovereign credit risk. The analysis suggests that the shape of the term structure conveys significant information on the relative importance of global and domestic risk. When the spread curve is upward sloping, global shocks are the dominant force underlying changes in the price of sovereign credit risk. Nonetheless, domestic shocks become relatively more important when the term structure is inverted. To draw these conclusions, I develop a recursive preference-based model with long-run risk for credit default swaps. The underlying default process, which modulates expectations about future default probabilities, is modeled to depend both on global macroeconomic uncertainty and country-specific risk. Time-variation in the slope can be explained through the joint dynamics of aggregate and idiosyncratic shocks in connection with investor preferences. Additional supporting evidence of the model-implied results is provided by empirical analysis using a panel of 44 geographically dispersed countries. First, the variation in spreads explained by their first common component decreases during the sovereign debt crisis. Second, country-specific fundamentals explain relatively more spread variation of distressed countries, which are characterized through a downward sloping spread curve. Third, the explanatory power of domestic factors is monotonically increasing with the number of months the term structure was inverted. Overall, these findings support the view that both sources of risk are important, they simply matter at different points in time.

Keywords: Credit Default Swaps, Default Risk, Sovereign Debt, Term Structure

JEL Classification: C1, E43, E44, G12, G15

Suggested Citation

Augustin, Patrick, The Term Structure of CDS Spreads and Sovereign Credit Risk (October 31, 2012). Available at SSRN: or

Patrick Augustin (Contact Author)

McGill University, Desautels Faculty of Management ( email )

1001 Sherbrooke Street West
Montreal, Quebec H3A 1G5


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