PDF Ebook The Sovereign Ceiling and Emerging Market Corporate Bond Spreads
We use the spreads of emerging market bonds traded in secondary markets to study investors’ perception of country risk. Specifically, we ask whether investors apply the “sovereign ceiling,” which says that no firm is more creditworthy than its government. To do this we compare the spreads of bonds issued by firms to those of bonds issued by the firms’ home governments. We identify some corporate bonds that trade at lower spreads than their governments, indicating that investors do not always apply the sovereign ceiling. For countries with lower perceived default risk, we find that investors do not believe that whenever the government defaults, the firm will default.
In April 1997, the credit rating agency Standard & Poor’s made a controversial announcement. It upgraded the debt of fourteen Argentinian firms, including three banks, to a rating higher than that accorded to Argentina’s sovereign debt. This decision ran counter to a long-standing policy of the credit rating industry to observe the “sovereign ceiling,” that is, the rule that no corporate debt can carry a rating higher than that of the firm’s home government. Moody’s, S&P’s principal competitor, argued that the move was irresponsible, and many market participants agreed. One emerging market analyst stated, “It’s a can of worms that S&P has opened up. They’ve blown their credibility.” (Euromoney 1997).
This debate reveals considerable disagreement about the nature of corporate default risk in emerging markets. It is clear that in emerging markets, which country a firm is located in is one of the most important factors in determining its default risk. But there is no consensus as to exactly why.
The sovereign ceiling may seem like a reasonable rule of thumb, as a first cut at determining the credit risk of a firm in an emerging market. Most companies are almost certainly riskier than their governments. However the rule itself only matters when it binds, and for companies whose ratings are constrained by the ceiling it has real effects. When S&P relaxed the rule in Argentina, the yield spreads of the affected companies narrowed by 30 to 50 basis points. Even apart from bond markets, investors’ perception of country risk has important implications for any decision about investment in emerging markets. Decisions about bank loans, foreign direct investment, and portfolio investment in developing countries depend crucially on how investors perceive the risks associated with the home country of the borrower or project.
The sovereign ceiling rule is related to the common practice of using sovereign spreads to impute the country risk associated with projects undertaken in emerging markets. One popular way to incorporate country risk is to add some risk premiums related to the sovereign spreads on to the cost of capital, under the argument that sovereign yield spread proxies for country related default risk for the firm.1 According to a survey conducted by Keck, Levengood and Longfield (1998), many practitioners add risk premiums into the discount rates to adjust for country risk. Once the sovereign ceiling rule was abolished, the spreads for the affected firms in Argentina narrowed by 30-50 basis points. If the sovereign ceiling affects the practitioners’ adjustment of cost of capital in emerging market projects by 50 basis points, then it poses an economically significant constraint to emerging market investment.2 Consider a project that yields an annuity cash flow of $100,000. With a 10% cost of capital, the project is worth $1 million. A decrease of the discount rate from 10% to 9.5% would increase the present value of the project by $52632. The method of accounting for country risk can thus have a big impact on what projects are undertaken in emerging markets.
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PDF Ebook The Sovereign Ceiling and Emerging Market Corporate Bond Spreads
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