A Term Structure Model for Defaultable Bonds with Macro and Latent Variables

We derive and estimate an affine no-arbitrage model with default risk and macroeconomic state variables to investigate the determinants of the term structure of emerging market external debt for Brazil, Colombia and Mexico. In particular we assess the importance of US macroeconomic factors, country's solvency ratios and latent variables in determining each country's term-structure. Our results indicate that: (i) the single most important variable is the joint latent variable interpreted as international liquidity, being more important in longer yields - it accounts for around 35% of the emerging markets 6 months duration spread movements and around 46% of 10 years duration spreads; (ii) the contribution of US macro variables ranges from 15% of the movements in short spread to 10% in the longer spreads; (iii) solvency variables are relatively more important to explain spreads in Mexico than in Brazil and Colombia; (iv) the idiosyncratic latent factor - interpreted as political risk - is also relevant accounting for approximately 30% of the movements, but its effect is larger on shorter yields