The Re-Pricing of Sovereign Risks Following the Global Financial Crisis

How strong has been the effect of the Global Financial Crisis (GFC) on systemic risk in sovereign bond markets? Was the increase in credit spreads relative to triple-A benchmarks which followed the GFC the result of higher sovereign credit risk or the result of a re-pricing that reflected changes in broader market conditions and risk aversion? In this paper we examine these issues by specifying a sovereign credit yield curve which relates sovereign yield spreads to credit ratings and global variables. The model allows for time-variation in both the price of credit risk and the average spread across all rating categories, which proxies the effect of global risk factors on yield spreads. We use daily data of ten-year bond yields and ratings from a large database of 64 countries, covering both emerging markets and developed economies, for the period from 1/1/2000 to 1/1/2015. Our estimates suggest that sovereign risk premia increased significantly after the GFC with most of the increase due to a re-pricing of broader market risks rather than an increase in the quantity or price of sovereign risk per se. This increase in global risk could be the result of a flight-to-quality from lower-rated sovereign bonds to AAA benchmark bonds. Interestingly, we find that global risk in the sovereign bond market is driven by global variables that relate to investor confidence, volatility risk, central bank liquidity and the slope of the yield curve in the US