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| Default and the Term Structure in Sovereign Bonds by Cristina Arellano of the University of Minnesota & Federal Reserve Bank of Minneapolis, and November 2006 Abstract: In emerging markets sovereign bonds of long maturity are issued mostly in tranquil times even though the spread curve is upward sloping. In crises times short maturity debt is issued and the spread curve is inverted. This paper builds a dynamic model of borrowing and default to study the optimal maturity composition when the term structure of sovereign bond spreads depends on endogenous default probabilities. The model generates a spread curve that is upward sloping on tranquil times because only the long spread will reflect the likelihood of a default far in the future. However if a default is likely in the near future the spread curve is inverted because the economy may repay its debt obligations in all future states if it avoids the stressed period. The model also delivers that long debt is issued primarily on tranquil times because it provides a good hedge against future bad shocks as long bonds effectively complete markets. We calibrate the model to Brazil and find that the model can match various features of the data including the dynamics of the spread curve and the volatility of long and short bonds spreads. Books Referenced in this Paper: (what is this?)
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