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Debt Dilution and Maturity Structure of Sovereign Bonds

The last decade has witnessed recurrent large-scale sovereign debt crises in many emerging markets, and most of them were resolved by debt renegotiations after default. These observances have aroused much interest in how composition and maturity structure of sovereign debts affect a country’s default probability and debt renegotiation outcome.

However, few have studied this problem the other way around. That is, when an emerging market is near financial distress, how do expectations of future default and debt renegotiations affect sovereign debt composition and maturity structure ex ante? This paper aims to answer this question and in particular, we study the effects of expected future default and debt restructuring on the ex ante maturity structure of sovereign debts.

It is already a well documented fact that the maturity structure of emerging market debt issuances correlates with their domestic conditions. That is, emerging markets issue long-term debts more in tranquil times, and issue short-term debts more when they are near crisis. Long-term spread is generally higher than short-term spread and this difference increases as the country approaches crisis (Broner, Lorenzoni and Schumukler (2005)). This paper constructs a dynamic model of sovereign borrowing, default and renegotiation to explain why expectations of default and debt restructuring in the near future drive the ex ante average debt maturity to be shorter.

In this model, we emphasize two risks that affect debt maturity structure: default risk and “debt dilution” risk. Default risk comes from the well-known willingness-to-pay problem and long-term debts usually bear higher default risk than short-term debts, since the latter are more likely to mature before crisis actually happens. Therefore, long-term spreads are generally higher than short-term spreads and the differences are even larger when default probability is high. Long-term debts can be too expensive to afford when a country is around crisis, and the country has to rely on short-term debts.

Debt Dilution and Maturity Structure of Sovereign Bonds