At a time when rising sovereign credit risk in highly indebted developed economies represents a major source of policy concern and market anxiety, drawing attention to the corporate debt problems that may loom ahead is not only a call for a more systematic approach to debt management, but an opportunity to highlight the hidden dynamics between sovereign and corporate debt that could create a negative feedback loop if investors lose confidence in the government’s ability to use public finances to stabilize the economy or provide a safety net for corporations in distress.
Though such sovereign credit events are rare, with global financial markets still unsettled and public finances stretched to the limit in many countries, their likelihood is rising, even in countries with seemingly manageable external debt profiles. Under such circumstances, markets’ assessment of public and private credit risk takes on a completely different dynamic than during normal times, when markets’ belief in a government’s power of taxation and spending provides a cushion against macroeconomic shocks. Understanding such market dynamics is, thus, crucial in formulating mitigating policy support measures before investor fear sets in that could have adverse consequences for private firms’ access to foreign capital.
This paper investigates the degree to which heightened sovereign default risk perceptions during times of market turmoil—gauged by widening of bond market spreads beyond a critical threshold—influence the determination of corporate bond yield spreads in emerging markets. Using a new database that covers nearly every emerging-market corporate and sovereign entity that has issued bonds on global markets between 1995 and 2009 (4,441 transactions, amounting to $1.46 trillion), we develop an empirical methodology to analyze whether sovereign risk is priced into corporate bond spreads, controlling for specific bond attributes and common global risk factors.
We model emerging corporate bond spreads as incorporating three risk premiums: corporate default, home-country sovereign debt distress, and a compensation for the fact that emerging bond market spreads vary systematically with global business cycle and with global financial market conditions. The first point, representing the standard credit risk component of corporate spreads, has received much attention in corporate finance literature, but the other two points are controversial and are based on two sets of considerations. First, private borrowing entities in emerging economies cannot insure the risk of their own home sovereigns through, for instance, selling protection in the credit derivatives swap (CDS) market; and second, emerging market investors are risk averse.