How do global investors differentiate between sovereign risks? The new normal versus the old

When global investors go into emerging markets or get out of them, how do they differentiate between economies? Has this behavior changed since the crisis of 2008 to reflect a “new normal”? We consider these questions by focusing on sovereign risk as reflected in monthly returns on credit default swaps (CDS) for 18 emerging markets and 10 developed countries. Tests for breaks in the time series of such returns suggest a new normal that ensued around October 2008 or soon afterwards. Dividing the sample into two periods and extracting risk factors from CDS returns, we find an old normal in which a single global risk factor drives half of the variation in returns and a new normal in which that risk factor becomes even more dominant. Surprisingly, in both the old and new normal, the way countries load on this factor depends not so much on economic fundamentals as on whether they are designated an emerging market.