Risk, Contract Terms and Maturity in the Sovereign Bond Market

Abstract

In this article we examine the relations between risk, the choice of foreign or local contract terms (parameters) and maturity in the sovereign debt market. Our primary finding is that the maturities of bonds that carry a meaningful degree of risk (rating BBB+ and below, which we label Lower Grade or LG) are greater when the bonds are written in foreign parameters. Relinquishing certain key contractual levers, capable of expropriating wealth from its bondholders once the bonds have been issued, provides investors with an enhanced commitment that the sovereign will pay the promised interest and principal. Correspondingly, the spread on LG bonds, written in foreign parameters, is less than the spread on bonds written under local parameters. Investors pay a premium for LG bonds with foreign parameters. We also find that the maturities of relatively safe bonds (rating above BBB+, which we label Upper Grade or UG) are greater than that of LG bonds. A UG rating provides sufficient credibility to honor longer maturity bonds. Finally, we find a positive relation between maturity and the bond’s S&P rating for the subsample of LG bonds. The higher the bond’s rating, the greater the commitment that the sovereign will repay the debt. Thus, we find a positive relation between bond ratings and maturities for this subset of the data.

Keywords: sovereign debt, maturity, foreign v. local parameters

JEL Classification: F3, F33, F34, K2, K22, H63, H74, H87