Aurora Borealis
1 August 2014 CFA Institute Journal Review

The Political Determinants of Sovereign Bond Yield Spreads (Digest Summary)

  1. Heather K. Traficanti

To determine what factors drive sovereign bond yield spreads, the author analyzes international political system characteristics. He finds that countries with parliamentary structures and low-quality governance face higher sovereign yield spreads than countries with presidential regimes. Autocratic countries with political stability and the power to implement austerity measures have significantly reduced sovereign yield spreads.

What’s Inside?

The author analyzes the political determinants of sovereign bond yield spreads using panel data for 27 emerging markets from 1996 to 2009. He studies how various political aspects determine sovereign bond yield spreads in emerging markets. Sovereign bond yield spreads offer several advantages compared with the sovereign debt default dummy variables used in other studies. In addition, the author considers a broad set of political aspects that may influence sovereign default risk.

How Is This Research Useful to Practitioners?

The author’s research may help sovereign debt investors more efficiently deploy their capital across multiple sovereignties with varying political systems by providing a fuller appreciation of the political effects on spreads. Included in the author’s analysis are the political system, elections, ideology, political stability, feasibility of policy change, and quality of governance. He also considers estimation results for models testing for nonlinear effects, for conditional effects in democratic versus autocratic regimes, and for conditional effects in closed versus open regimes. The author also performs robustness checks.

Presidential regimes generally face lower sovereign bond yield spreads than parliamentary regimes because it is more difficult to unseat the chief executive in a presidential system and because a presidential government may be more willing to make such unpopular decisions as implementing austerity budgets. Stability and power are found to be important characteristics in reducing sovereign bond yield spreads, particularly in autocratic regimes. Furthermore, improving the quality of governance helps to reduce sovereign bond yield spreads, as does improving the efficiency of the legal system, administration, and regulations. The relevance of political variables for the determination of sovereign bond yield spreads is much higher for autocratic and closed regimes than for democratic and open countries. Additionally, the democratization of societies and faster integration of emerging markets into the world economy reduce the impact of politics on sovereign bond yield spreads.

The most important variables affecting the sovereign bond yield spreads are the following: the occurrence of an assembly-elected president, the investment-to-GDP ratio, the reserve-to-import ratio, the current account balance, the Treasury–Eurodollar spread, the incidence of prior sovereign default, rule of law, the regulatory quality, government effectiveness, the external-debt-to-GDP ratio, the overall political stability index, polarization (the variable that measures the maximum difference between the executive party’s values and the values of the three largest government parties), voice and accountability, checks and balances, control of all houses, left-party government, the military, and the overall index of economic freedom.

How Did the Author Conduct This Research?

To measure sovereign default risk in a country, the author uses the yield spread between domestic and US sovereign bonds and assumes that US sovereign bonds are risk free. The yield spread measures the expected loss for the investor associated with a potential sovereign default of the considered emerging market government. The data on the sovereign bond yield spreads are obtained from the Emerging Market Bond Index (EMBI) provided by J.P. Morgan. The EMBI includes Brady bonds, loans, and Eurobonds issued by the federal government with an average maturity of 12 years, and it averages yield data from the most liquid bonds. The minimum size of a debt instrument to be included in the EMBI is outstanding debt exceeding $500 million, which guarantees that relatively liquid instruments with reasonable prices are considered.

The author takes into account the following six political variables: the nature of the political system, elections, ideology, political stability, feasibility of political change, and the quality of governance. To describe the political system, he uses the Policy 2 score, whereby higher values indicate more democratic regimes and lower values indicate more autocratic regimes.

The empirical analysis includes baseline regressions, robustness checks, nonlinear effects, and conditional effects. The robustness checks and nonlinear effects explain the results of five sensitivity checks referred to as the five specifications.

The first specification uses the mean value of daily EMBI spreads in each year as the dependent variable. The second specification uses such additional control variables as the debt-service-to-GDP ratio and the external financial requirements ratio proposed by Manasse and Roubini (Journal of International Economics 2009). The third specification uses the projected GDP growth, and the fourth specification excludes observations following the year of a country’s initial entry into sovereign default. The fifth specification uses all the explanatory variables lagged one year.

Abstractor’s Viewpoint

The author leverages prior research from notable publications and focuses on the political aspects of sovereign default risk, an approach few researchers have taken. The two conclusions that resonated with me are that sovereign risk is higher for parliamentary systems than for presidential regimes and that political determinants are most important in autocratic and closed regimes. The research is well organized and has a logical flow; the definitions and sources of variables are clearly presented.

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