Sovereign risk and its changing effects on bond duration during financial crisis

Abstract

We examined the effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996 to 2011. We compared the sovereign risk-adjusted duration with the Macaulay duration for both investment-and speculative-grade US dollar-denominated sovereign bonds. We found that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all ratings, and the 'shortening' effect is stronger for lower rated bonds, which generally intensified during the recent financial crisis. Results are robust when credit default swap (CDS) prices are used as a proxy for changes in sovereign risk. This study provides evidence for advocating the importance of adjusting the bond duration for sovereign risk. More important, this study provides a practical methodology for estimating a sovereign riskadjusted duration measure for managing international bond portfolios.