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Sovereign debt distress and corporate spillover impacts

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  • Dailami, Mansoor

Abstract

In much of the standard corporate finance literature in which sovereign debt is treated as a risk free asset, corporate bond prices are seen to depend on idiosyncratic risk factors specific to the issuing company, with public debt playing an indirect role to the extent that it affects the term structure of interest rates. In the corporate world, however, the ability of a borrower to access international capital markets and the terms according to which it can raise capital depend not only on its own creditworthiness, but also on the financial health of its home-country sovereign. In times of financial stress, when investors lose confidence in the government's ability to use public finances to stabilize the economy or provide a safety net for corporations in distress, markets'assessment of private credit risk takes on a completely different dynamic than during normal times, incorporating an additional risk premium to compensate investors for the potential consequences of sovereign default. Using a new database that covers nearly every emerging-market corporate and sovereign entity that has issued bonds on global markets between 1995 and 2009, this paper investigates the degree to which heightened sovereign default risk perceptions during times of market turmoil influence the determination of corporate bond yield spreads, controlling for specific bond attributes and common global risk factors. Econometric evidence presented confirms that investors'perceptions of sovereign debt problems translate into higher costs of capital for private corporate issuers, with the magnitude of such costs increasing at times when sovereign bonds trade at spreads exceeding a threshold of 1000 bps. The key policy recommendation emerging from the analysis relates to the need to improve sovereign creditworthiness in order to prevent a loss in investor confidence that could trigger a panicky sell-off in sovereign debt with adverse macroeconomic and fiscal consequences. Implications for future research point to the need to develop better models of corporate bond pricing and valuation, recognizing explicitly the role of sovereign credit risk.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 5380.

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Date of creation: 01 Jul 2010
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Handle: RePEc:wbk:wbrwps:5380

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Keywords: Debt Markets; Emerging Markets; Banks&Banking Reform; Markets and Market Access; Deposit Insurance;

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References

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  1. Dailami, Mansoor & Masson, Paul R. & Padou, Jean Jose, 2005. "Global monetary conditions versus country-specific factors in the determination of emerging market debt spreads," Policy Research Working Paper Series 3626, The World Bank.
  2. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
  3. Amadou N. R. Sy & Andrea Pescatori, 2004. "Debt Crises and the Development of International Capital Markets," IMF Working Papers, International Monetary Fund 04/44, International Monetary Fund.
  4. Dailami, Mansoor & Masson, Paul, 2009. "Measures of investor and consumer confidence and policy actions in the current crisis," Policy Research Working Paper Series 5007, The World Bank.
  5. Robert F. Dittmar, 2008. "Do Sovereign Bonds Benefit Corporate Bonds in Emerging Markets?," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(5), pages 1983-2014, September.
  6. Udaibir S. Das & Michael G. Papaioannou & Christoph Trebesch, 2010. "Sovereign Default Risk and Private Sector Access to Capital in Emerging Markets," IMF Working Papers, International Monetary Fund 10/10, International Monetary Fund.
  7. Christoph Trebesch, 2009. "The Cost of Aggressive Sovereign Debt Policies," IMF Working Papers, International Monetary Fund 09/29, International Monetary Fund.
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Cited by:
  1. Mansoor Dailami, 2012. "Looking Beyond the Euro Area Sovereign Debt Crisis," World Bank Other Operational Studies 10050, The World Bank.
  2. Klein, Christian & Stellner, Christoph, 2014. "Does sovereign risk matter? New evidence from eurozone corporate bond ratings and zero-volatility spreads," Review of Financial Economics, Elsevier, Elsevier, vol. 23(2), pages 64-74.

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