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Debt Dilution and Maturity Structure of Sovereign Bonds

  • Ran Bi
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    We develop a dynamic model of sovereign default and renegotiation to study how expectations of default and debt restructuring in the near future affect the ex ante maturity structure of sovereign debts. This paper argues that the average maturity is shorter when a country is approaching financial distress due to two risks: default risk and "debt dilution" risk. Long-term yield is generally higher than short-term yield to reflect the higher default risk incorporated in long-term debts. When default risk is high and long-term debt is too expensive to afford, the country near default has to rely on short-term debt. The second risk, "debt dilution" risk, is the focus of this paper. It arises because there is no explicit seniority structure among different sovereign debts, and all debt holders are legally equal and expect to get the same haircut rate in the post-default debt restructuring. Therefore, new debt issuances around crisis reduce the amount that can be recovered by existing earlier debt-holders in debt restructuring, and thus ``dilute'' existing debts. As a result, investors tend to hold short-term debt which is more likely to mature before it is "diluted" to avoid the "dilution" risk. Model features non-contingent bonds of two maturities, endogenous default and endogenous hair cut rate in a debt renegotiation after default. We show that ``debt dilution'' effect is always present and is more severe when default risk is high. When default is a likely event in the near future, both default risk and ``dilution'' risk drive the ex ante maturity of sovereign debts to be shorter. In a quantitative analysis, we try to calibrate the model to match various features of the recent crisis episode of Argentina. In particular, we try to account for the shifts in maturity structure before crisis and the volatility of long-term and short-term spreads observed in the prior default episode of Argentina

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    File URL: http://repec.org/sed2006/up.27389.1140027188.pdf
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    Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 652.

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    Date of creation: 03 Dec 2006
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    Handle: RePEc:red:sed006:652
    Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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    1. Herschel I. Grossman & John B. Van Huyck, 1985. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," NBER Working Papers 1673, National Bureau of Economic Research, Inc.
    2. Brian D. Wright & Kenneth M. Kletzer, 2000. "Sovereign Debt as Intertemporal Barter," American Economic Review, American Economic Association, vol. 90(3), pages 621-639, June.
    3. Diego Saravia, 2009. "On The Role and Effects of IMF Seniority," Working Papers Central Bank of Chile 538, Central Bank of Chile.
    4. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-Fulfilling Debt Crises," Levine's Working Paper Archive 114, David K. Levine.
    5. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc.
      • Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
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