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Sovereign Debt Crises through the Prism of Primary Bond Markets

The aim of this paper is to study the recent sovereign debt crises from the structure of the primary market. We examine the behaviour and interactions between the three major actors of the Sovereign Bond Market (i.e, governments, investment banks/lead managers and investors), prior and following a sovereign debt crisis. To this end we analyse important, yet often overlooked in the research literature, sources of information pertaining to price formation on the primary market for sovereign bonds. Particularly the remuneration governments pay investment banks to place bonds (i.e., underwriting spread), and the primary price at which these bonds are bought by investors.

The empirical evidence that we present in this paper suggests that we cannot reject the hypothesis that investment banks were better informed than investors before the above mentioned crises. The finding of this paper suggests that investment banks price sovereign default risk well before crises and even before investors. This is a puzzle in that it appears that investors are not using potentially useful (and public) information in order to allocate efficiently their portfolios of emerging fixed incomes assets.

Of course, information problems in sovereign bond markets are not limited to nowadays. The paucity of information available to investors on developing countries was impressive. Examples abound on inefficiencies and market frictions due to such lack of information, surely the most famous of which being the bonds of Poyais. Gregor McGregor, a Scottish adventurer who fought alongside Bolívar, styled himself the Prince of an imaginary state in South America Poyais and was received with his wife (Bolivar’s niece) at the court of George IV as honoured guests.

Having fooled the royals, Poyais bonds were issued and traded in London in the 1820s. The discovery of the fraud precipitated one of the first big series of Latin defaults. It remains astonishing that the information asymmetries of the time allowed the imaginary kingdom of Poyais to borrow on the same terms as legitimate states such as Chile, Colombia or Peru.

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Sovereign Debt Crises through the Prism of Primary Bond Markets