Sovereign default and maturity choice

Abstract

This study develops a novel model of endogenous sovereign debt maturity choice that rationalizes various stylized facts about debt maturity and the yield spread curve: first, sovereign debt duration and maturity generally exceed one year, and co-move positively with the business cycle. Second, sovereign yield spread curves are usually non-linear and upward-sloped, and may become non-monotonic and inverted during a period of high credit market stress, such as a default episode. Finally, output volatility, sudden stops, impatience and risk aversion are key determinants of maturity, both in our model and in the data.

Sovereign Debt Restructurings

“…The work of Arellano and Ramanarayanan (2012) allows for the choice of long-term debt by having a short bond and a consol. We model debt maturity as the choice of a discrete number of periods following Sánchez, Sapriza, and Yurdagul (2018), which is computationally convenient for the application of dynamic discrete choice methods.…”

“…We complement their analysis by focusing on the implications for sovereign debt maturity. Specifically, to the extent that sovereign debt maturity is procyclical (see for instance Sánchez, Sapriza, and Yurdagul (2018)), the output recovery between the period of default and restructuring implies that the maturity of the new debt chosen upon settlement would be larger than the maturity of debt at the time of default. Note: The log of maturity extensions is conditional on the log of debt to GDP.…”

“…It is well known that, for borrowers, long-term debt is more costly than short-term debt due to debt dilution. However, borrowers value long-term debt as a way to hedge against rollover crises or sudden stops (see Sánchez et al (2018) for a discussion.) In our quantitative exercises and for our preferred calibration, only 17.5% of all default episodes occur jointly with a sudden stop.…”

“…21 We set the yearly risk-free interest rate to 4.2% to match the long-run average of the real 10-year U.S. Treasury bonds yield. 22 The standard deviation of the income shock is set to 0.019, and the persistence is set to 0.86, to replicate the yearly detrended GDP per capita process for Colombia as estimated in Sánchez, Sapriza, and Yurdagul (2018).…”

“…Duration. Similar to Hatchondo and Martinez (2009) and Sánchez, Sapriza, and Yurdagul (2018), we use the Macaulay definition to compute the duration of a bond as a weighted sum of future promised payments:…”