Effects of Sovereign Risk on Duration : Evidence from European and Latin American Sovereign Bond Markets

We examine effects of sovereign risk on bond duration in European and Latin American sovereign bond markets over the period 1996-2011. We compare the sovereign risk-adjusted duration for U.S. dollar-denominated sovereign bonds with their Macaulay duration for both investment- and speculative-grade bonds. We find that the sovereign risk-adjusted duration is significantly shorter than its Macaulay counterpart for all bonds, regardless of the bond rating and maturity. Further, the “shortening” effect of sovereign risk on duration is generally stronger among bonds of lower ratings. During the recent global financial crisis, the “shortening” effect was dampened for quality sovereign bonds. But the sovereign risk effect on duration was intensified for BBB and BB rated bonds, reflecting investors' perception of increasing likelihood of default by issuing nations. Results are robust when CDS prices are used as a proxy for changes in sovereign risk. Moreover, the regional analysis shows that sovereign risk shortens duration much less for sovereign bonds issued by the EU and Latin American countries than for non-EU member counterparts. Our study demonstrates the importance of, and provides a practical guide for, bond portfolio managers to account for sovereign risk in managing interest rate risk exposure in their investments