Disentangling the Information Content of Government Bonds and Credit Default Swaps: An Empirical Analysis on Sovereigns and Banks

Abstract

We propose a multi-factor Gaussian model to analyze the dynamics of sovereign bond yields, as well as sovereign and banks CDS quotes. This paper has three objectives (all of them with relevant implications from a supervisory perspective): (1) disentangling the credit risk component of sovereign bonds from the interest rate component; (2) exploring the sovereign CDS-bond basis, i.e., the difference between sovereign CDS quotes and the corresponding bond yields; (3) inferring from CDS quotes the idiosyncratic component of a bank credit risk and analyzing its relation with sovereign risk. We cast the model in a state-space form with linear measurement function. To calibrate the model we consider a maximum likelihood estimation together with a Kalman filter method in which both the gradient vector and the Hessian matrix to be used in the optimization can be computed in closed form.

Examining the Sources of Sovereign Risk for South Africa: A Time Varying Flexible Least Squares Approach

“…The information content of sovereign yield spreads is well documented in literature and several studies have investigated the major determinants of the sovereign yield spread (Wellmann and Trück, 2018;Bianchi and Rocco, 2016). However, less attention has been given to analysis of sovereign risk in emerging and developing economies despite high risk associated with investments in these countries.…”