Sovereign bond ratings and market spreads. a dynamic panel analysis

This paper applies a measure of country risk to determine the evolution of credit spreads on secondary market sovereign bonds issued by emerging countries. After the Mexican financial crisis in 1995, this market has been characterised by a sharp decline of spreads which, by mid-1997, brought them to a level which was thought not to adequately cover risk. The episode has been followed in successive years by a new increase of spreads, accompanied by high volatility in concomitance with the Asian and Russian crises. In order to tackle the issue of how preads are determined, we concentrate on sovereign risk as measured by spreads on Brady bonds and specify a dynamic panel model including seven countries that are large issuers of these instruments. The analysis reveals a significant effect for economic fundamentals, but we also found that spreads are significantly affected by shock factors: besides general financial crises, we isolated a role for commodity prices. We found an asymmetric effect for core countries interest rates, which signals the limited role for core rates in affecting the decline in spreads, that we instead attribute, besides a bettering of fundamentals, to a spreading of lobalisation. In the post ‘97 period we found spreads grossly in line with fundamentals but we have no specific explanation to offer for the occurrence of repeated financial crises save that a general recourse to the argument of nterdependence. We think that the analysis of contagion or interdependence problems that has recently attracted much attention obviously deserves further work and possibly a different econometric technique using data at a higher frequency than the monthly data employed in this study.