Debt Dilution and Maturity Structure of Sovereign Bonds

We develop a dynamic model of sovereign default and renegotiation to study how expectations of default and debt restructuring in the near future affect the ex ante maturity structure of sovereign debts. This paper argues that the average maturity is shorter when a country is approaching financial distress due to two risks: default risk and "debt dilution" risk. Long-term yield is generally higher than short-term yield to reflect the higher default risk incorporated in long-term debts. When default risk is high and long-term debt is too expensive to afford, the country near default has to rely on short-term debt. The second risk, "debt dilution" risk, is the focus of this paper. It arises because there is no explicit seniority structure among different sovereign debts, and all debt holders are legally equal and expect to get the same haircut rate in the post-default debt restructuring. Therefore, new debt issuances around crisis reduce the amount that can be recovered by existing earlier debt-holders in debt restructuring, and thus ``dilute'' existing debts. As a result, investors tend to hold short-term debt which is more likely to mature before it is "diluted" to avoid the "dilution" risk. Model features non-contingent bonds of two maturities, endogenous default and endogenous hair cut rate in a debt renegotiation after default. We show that ``debt dilution'' effect is always present and is more severe when default risk is high. When default is a likely event in the near future, both default risk and ``dilution'' risk drive the ex ante maturity of sovereign debts to be shorter. In a quantitative analysis, we try to calibrate the model to match various features of the recent crisis episode of Argentina. In particular, we try to account for the shifts in maturity structure before crisis and the volatility of long-term and short-term spreads observed in the prior default episode of ArgentinaMaturity Structure, Debt Dilution, Sovereign Default, Debt Renegotiation

Sovereign Default Risk Premia, Fiscal Limits and Fiscal Policy

We develop a closed economy model to study the interactions among sovereign risk premia, fiscal limits, and fiscal policy. The stochastic fiscal limits, which measure the ability and willingness of the government to service its debt, arise endogenously from a dynamic Laffer curve. The distribution of fiscal limits is country-specific, depending on the size of the government, the degree of countercyclical policy responses, economic diversity, and political uncertainty, among other characteristics. The model rationalizes different sovereign ratings across developed countries. A nonlinear relationship between sovereign risk premia and the level of government debt, which emerges in equilibrium, is consistent with the empirical evidence that once risk premia begin to rise, they do so rapidly. Movements in default risk premia for long-term bonds precede those for shortterm bonds, providing early warnings of increasing probabilities of sovereign defaults.Fiscal policy; International topics