The sovereign debt market has grown over the past few years, providing an important source of diversification for global portfolios and affecting investment flows and funding costs. The authors examine the drivers of sovereign credit spreads and conclude that global financial factors, rather than country-specific factors, are largely responsible for changes in spreads.
The authors study the nature of sovereign risk by measuring the sensitivity of credit default swap (CDS) spread changes to such different market factors as stock market returns, exchange rates, volatility premium, and fund flows, among others. Although a number of previous authors have studied factors behind CDS spreads, this study uses a more comprehensive dataset and a richer modeling approach than its predecessors.
The set of factors consists of 14 variables in the following five groups: global financial market, risk premium, liquidity, regional spreads, and local market factors. The authors complement regressions of spread changes on local and global factors with the affine model, which decomposes CDS spreads into risk premium and default risk components. They further explore whether the risk premium or default risk is more closely related to global factors.
The dataset consists of CDS spreads from 26 developed and developing countries, measured monthly, from October 2000 to January 2010. The authors find a number of important results. First, sovereign credit spreads between different countries are highly correlated. Principal component analysis shows that the first component explains roughly 64 percent of variance in spreads, a figure much higher
than the corresponding one for equity returns (46 percent).
Second, the main source of corresponding movement is the result of global factors rather than country-specific risk. Although the effects of four sets of local and global variables are all statistically significant, sovereign CDS spreads are most strongly influenced by the U.S. stock market, the high-yield market, and the volatility risk premium.
Third, the authors use the term structure of credit spreads to fit an affine model, and they find that the risk premium accounts for approximately one-third of the credit spreads. Fourth, although the risk premium and default risk are both closely related to global factors, default risk dominates the relationship.
Sovereign credit spreads have been studied in the past, but the authors add to the available information about the driving forces behind spread movements. They include a longer history compared with previous studies in order to identify significant factors, and they supplement the history with a model that attributes spreads to the risk premium and default risk. The authors believe their insights about the effects of global factors on CDS spreads are important because they highlight more than the interconnectedness of the world economies; they also highlight the increased presence of investors with global portfolios and the significance of global capital flows.
Swaps Markets and Instruments
Analysis of Credit Risk