On the Design of Sovereign Bond-Backed Securities

Abstract

We analyze Sovereign Bond-Backed Securities, concentrating our attention on the return of the different tranches and on their risk. We show that as the correlation level among defaults increases, the yield rate of senior tranches increases while the yield rate of junior tranches decreases. A similar effect is observed when introducing a block dependence structure with high correlation among states belonging to the same block. Introducing a non-zero recovery rate, as opposed to a null recovery rate, decreases the yield rate of senior tranches and increases the yield rate of junior tranches. We compute the loss distribution and the Value at Risk (VaR) associated with the market risk of detaining the different tranches of the bond. We also analyze the possibility of reaching a safe asset through pooling tranches of government bonds of different States. In summary, we show that the issue in reaching a comprehensive and safe offering through the securitization of government bonds is not the safety of senior tranches but the risk of the junior ones.

Keywords: Sovereign bond-backed securities, tranches, diversification, Euro

JEL Classification: C60, F34, F36, F45, G28