Inside the Risky Sovereign Bond Spreads and CDS-bond Basis: EMs, DMs, and the Eurozone

Abstract

This paper examines a no-arbitrage framework for pricing and relative value analysis of multi-currency sovereign bonds. We consider three cases based on the issuer: (i) an emerging market (EM) country with outstanding bonds in both foreign hard currency (Eurobonds) and local soft currency (treasuries), (ii) a developed market (DM) country issuing both local currency and foreign multi-currency debt, and (iii) a Eurozone (EZ) member country issuing both euro-denominated and foreign multi-currency debt. The resulting yield curves give rise to credit and currency spreads, which require further examination. We discuss their proper measurement, derive and analyze the necessary no-arbitrage conditions, and quantify the inherent risk premia. We then shift focus to the CDS-bond basis in this multi-curve environment. The concept exhibits certain theoretical and empirical nuances across different types of sovereign issuers. The paper explores these distinctions, emphasizing their implications. While measuring the basis in the standard case of single-currency debt remains challenging, the complexity increases significantly in a multi-curve setting. We investigate this issue and provide relevant theoretical insights and empirical analysis.

Keywords: foreign debt, domestic debt, risky spread, risk premia, CDS-bond basis

JEL Classification: F31, G12, E43, C58