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Default and the Maturity Structure in Sovereign Bonds

by Cristina Arellano of the Federal Reserve Bank of Minneapolis & University of Minnesota, and
Ananth Ramanarayanan of the Federal Reserve Bank of Dallas

April 30, 2010

Abstract: During emerging market crises, government interest rate spreads rise, the debt maturity shortens and the spread on short-term bonds is higher than on long-term bonds. This paper studies the maturity composition of debt in a dynamic model with endogenous default, in which the price of debt compensates for the risk-adjusted losses from default. Short-term debt is better at inducing repayment because it does not require savings in the near future for repaying in the far future. Hence, short-term debt can raise more resources than long-term debt. However, issuing long-term debt provides a hedge against the need to roll-over short-term debt at high interest rate spreads. The trade-off between these two benefits is quantitatively important for understanding the maturity composition in emerging markets. When calibrated to data from Brazil, the model matches the dynamics in the maturity of debt issuances and its co-movement with the level of spreads across maturities.

Previously titled: Default and the Term Structure in Sovereign Bonds

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