Sovereign credit and exchange rate risks: evidence from Asia-Pacific local currency bonds

BIS Working Papers  |  No 918  | 
13 January 2021
by Mikhail Chernov, Drew Creal and Peter Hördahl
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  |  60 pages

Summary

Focus

We study the dynamic properties of sovereign bonds in emerging market economies and their associated risk premiums. We focus on the interaction between credit and currency risks, ie the Twin Ds, reflected in local currency bonds issued by sovereigns in Asia-Pacific (AP).

Contribution

We contribute to the literature on determinants of sovereign credit spreads by establishing evidence on how financial markets perceive and value the joint risk of sovereign default and its currency devaluation (the Twin Ds). Understanding this risk is important as credit and exchange rate risks may reinforce one another on the way towards economic and financial distress, and may therefore result in sizeable risk premiums. Local currency (LC) bonds offer an ideal source of information about the Twin Ds because international investors who take positions in such assets are exposed to both credit and exchange rate risks. In modelling these risks, we allow for two "global" anchors – US and Chinese – to potentially affect local AP factors and LC bond prices.

Findings

Relying on the term structure of LC bonds issued by Asia-Pacific sovereigns, we find strong interaction between credit and currency risks. The risk premium for this interaction is economically comparable to interest rate and credit risks. Moreover, we find that local variables are significant in the dynamics of currency and credit risk, and in the components of bond risk premiums that reflect these risks. The risk-return trade-off from exposure to the Twin Ds risk is attractive, as investing in LC debt more than doubles the maximum Sharpe ratio compared with investment in global (US and Chinese) bonds only.

Abstract

We study the dynamic properties of sovereign bonds in emerging market economies and their associated risk premiums. We focus on the properties of credit spreads, exchange rates, and their interaction. Relying on the term structure of local currency bonds issued by Asia-Pacific sovereigns, we find that local variables are significant in the dynamics of currency and credit risk, and the components of bond risk premiums reflecting these risks. Local currency bonds dramatically improve the investment frontier.

JEL Codes: F31, G12, G15

Keywords: emerging bond markets, credit risk, currency risk, Twin Ds, affine model