Illiquidity in Sovereign Debt Markets

Abstract

We study debt policy of emerging economies accounting for credit and liquidity risk. To account for credit risk we study an incomplete markets model with limited commitment and exogenous costs of default following the quantitative literature of sovereign debt. To account for liquidity risk, we introduce search frictions in the market for sovereign bonds. In our model, default and liquidity will be jointly determined. This permits us to structurally decompose spreads into a credit and liquidity component. To evaluate the quantitative performance of the model we perform a calibration exercise using data for Argentina. We find that introducing liquidity risk does not harm the overall performance of the model in matching key moments of the data (mean debt to GDP, mean sovereign spread and volatility of sovereign spread). At the same time, the model endogenously generates bid ask spreads, that can match those for Argentinean bonds in the period of analysis. Regarding the structural decomposition, we find that the liquidity component can explain up to 50 percent of the sovereign spread during bad times; when the sovereign is not close to default, the liquidity component is negligible. Finally, regarding business cycle properties, the model matches key moments in the data. * We would like to thank Robert Townsend, Ivan Werning, George-Marios Angeletos and Alp Simsek for continuous support, guidance, and helpful comments on various stages of this project. We would also like to thank Nicolas Caramp, Arnaud Costinot, Athanasios Orphanides, Dejanir Silva and participants in the MIT International Lunch for helpful comments. We thank the Macro-Financial Modeling Group for financial support. All errors are our own. First Version: November 2014.

What Went Wrong?: The Puerto Rican Debt Crisis, the 'Treasury Put,' and the Failure of Market Discipline

“…An alternative explanation of our results is that the purported rise in the risk premium merely reflects a rise in the liquidity premium on uninsured bonds (Passadore and Xu, 2018), as investors largely withdrew from the uninsured bond market after the Detroit shock. Trading volume of uninsured bonds fell by 21% between the Before and After intervals.…”

“…The liquidity premium is an important component of municipal debt Longstaff (2011). documents that the liquidity premium is quantitatively important for short-term municipal securities; even in a rather liquid segment of the market, it averages 56 basis points for the period 2001-2009.Ang and Green (2011, citing Ang, Bhansali, and Xing (n.d.)) report that the liquidity premium on municipals averages 112 basis points Passadore and Xu (2018). show that the liquidity premium varies substantially by default state, accounting for one-half of the sovereign spread during periods of financial distress but only a negligible amount otherwise.…”

The Search Theory of OTC Markets

“…An emerging literature considers international economics applications. Geromichalos and Jung (2018), Malamud and Schrimpf (2018) and Bianchi, Bigio, and Engel (2018) study the foreign exchange market, while Passadore and Xu (2018) and Chaumont (2018) study the interplay between liquidity and default for sovereign debt, by integrating a secondary OTC market in the model of Eaton and Gersovitz (1981).…”

“…Ever since Duffie, Gârleanu, and Pedersen (2007), many authors have combined their theoretical analyses with calibrations. This includes Vayanos and Weill (2008) for the spread between on and off the run bonds, He and Milbradt (2014) Chen, Cui, He, and Milbradt (2018), and d'Avernas (2017 for decompositions of credit spread between default and liquidity components, Passadore and Xu (2018) and Chaumont (2018) for sovereign spreads, Afonso and Lagos (2015b), Armenter and Lester (2017) and Afonso, Armenter, and Lester (2019) and Bianchi and Bigio (2014) for quantitative policy experiments in the Federal Funds market, Pagnotta and Philippon (2018) for a welfare analysis of speed competitions between exchanges, Hugonnier, Lester, and Weill (2019) for a decomposition of the gains from trade in the muni market, Kozlowski (2018) for an quantitative analysis of maturity choice when debt is traded in OTC market.…”

Improving Sovereign Debt Restructurings

“…Mihalache (2017) explores sovereign debt restructurings and maturity extensions appealing to political economy considerations. Passadore and Xu (2018) introduces bonds with long maturity and debt restructuring in a sovereign default model, but focuses on illiquidity in the secondary markets of sovereign debt and considers both the maturity and the outcomes of debt restructurings to be exogenous. The closest to our framework is the work of Dvorkin, Sánchez, Sapriza and Yurdagul (2019), which explains why debt maturity extensions are usually the output of debt restructurings.…”