Sovereign Overhang and the Integration of Equity and Credit Markets Around the World

Abstract

As governments around the world steadily assume greater financial risk, there is concern about the growing sovereign risk that overhangs the private sector. This paper demonstrates that sovereign risk serves as a unifying factor for the pricing of private sector assets, manifesting through higher R2s in equity and credit returns and stronger synchronicity between asset classes. Widening sovereign CDS spreads signal impending economic policy uncertainty (EPU), diverting investor attention away from firm-specific events and amplifying the role of credit markets in price discovery. Strong property rights protections and rule of law mitigate the dissemination of sovereign risk, while financial institutions and economies with more credit to government entities are especially vulnerable. Our findings provide novel insights into the sovereign-corporate nexus and cross-asset market dynamics, offering implications for global asset pricing and financial stability. 

Keywords: Equity-Credit Integration, Systematic Risk, Economic Development, Property Rights, Economic Policy Uncertainty

JEL Classification: G12, G14