Loss Aversion and Search for Yield in Emerging Markets Sovereign Debt

Empirical evidence indicates that a decline in international risk-free interest rates decreases emerging markets (EM) sovereign spreads. A standard quantitative model of sovereign default, calibrated to match average levels of debt and spread, does not replicate this feature even if the risk aversion of lenders moves with international interest rates. In this paper, I show that a model with lenders that are loss-averse and have reference dependence, traits suggested by the behavioral finance literature, replicates the noticed stylized fact. In this framework, when international interest rates fall, EM sovereign spreads decline despite increases in debt and default risk. This happens because investors search for yield in risky EM bonds when the risk-free rate is lower than their return of reference. I find that larger spread reductions occur for i) riskier countries; ii) greater declines in the risk-free rate; and iii) higher degrees of loss aversion.