15th World Congress of the International Economic Association

Sovereign Debt Crises through the Prism of Primary Bond Market

Sebastian Nieto Parra

Sciences Po Paris, Chaire Finances Internationales OECD Development Centre

Istanbul, June 2008

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Motivation
Inefficiency in sovereign bond markets
Asymmetries of information between capital markets actors

Behaviour and interactions between the three major actors of the Sovereign Bond Market : Governments Investment banks/lead managers Investors
It concerns the advantage of information that investment banks may have over investors.
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Motivation
Structure of the Prices in the Sovereign Bond Market
Pt fee

Governments
PT

Investment Banks

P t T

C ( PT t )

Pt C ( Pt )

Where: T: t: C: P: Maturity date Issue date Commission paid by investors to Investment banks Price of the sovereign bond (Financial transaction that it is the counterparty of the transfer of the security).
fee : Underwriting spread paid by governments to investment banks

Investors

Motivation
Primary and secondary sovereign bond markets provide important information concerning risk perception of capital markets actors Risk perception of investors can be measured by the Sovereign bond spreads on the primary and secondary market
Risk perception of investment banks can be measured by the remuneration that governments pay to investment banks in order to place bonds (i.e., underwriting fee) 4

Review of the literature

Information problems in the emerging sovereign bond market
- Flores (2007), and Flandreau and Flores (2007): Historical point of view. Role
of underwriters as providers of information for investors. Nieto-Parra and Santiso (2007): Positive recommendations given by Investment Banks when they are acting as Lead Managers. Edwards (1997): Information pb between Wall Street analysts and their clients during the Mexican crisis of 1994 Blustein (2003): Conflict of interest with which Investment banks are faced during the Argentinean crisis of 2001. Calomiris (2003): Cooperation between research and origination departments.

They are not followed by a systematic analysis of the structure of the primary bond market. Information problems for the recent sovereign debt crises.
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Review of the literature

Vast and relevant research literature on the primary corporate bond market 1 Literature related to the determinants of the underwriting fee:
West (1967), Sorensen (1979), Higgins and Moore (1980), Kryzanowski et al. (1996), Lee et al. (1996), Altinkihc and Hansen (2000), How and Yeo (2000), Livingston and Miller (2000), Kollo and Sharpe (2002), Livingston and Zhou (2002) and Hua-Fang, (2005)

Credit risk and profitability indicators are explanatory variables of the underwriting fee. 2 Relationship between the primary market and the recommendations given by underwriters:
- Lin and McNichols (1998), Chen and Ritter (2000), Ljungqvist et al. (2006),
Bradley et al. (2003), and Michaely and Womack (1999).
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Description of the data

Period: 1993-2006 Frequency: Annual 29 Countries: EMBI Index (JP Morgan) and countries for whom we have information on underwriting fee
Argentina, Brazil, Bulgaria, Chile, China, Colombia, Dominican Republic, Ecuador, Egypt, El Salvador, Hungary, Indonesia, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Thailand, Turkey, Ukraine, Uruguay, Venezuela and Vietnam.

1 Structure of the primary bond market (Underwriting fee and Primary sovereign bond spread): Standard issues: (i) ISIN reference number
(ii) (iii) Coupon rate is not float Currency denomination (EUR, JPY, USD) No guarantee for the issue

(iv)

Description of the data

427 issues (67% denominated in USD, 28% in EUR and 5% in JPY) Annual average of the underwriting fee and primary sovereign bond spread of the emerging countries

2 Secondary Sovereign bond spread (EMBI Index, JPMorgan)

3 Information received by investors from investment banks concerning the primary bond market we collect the major investment banks publications published by the most important financial actors in emerging countries.
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Sovereign Debt Crises

Standard definition employed mostly on the early warning models, a country is defined to be in a debt crisis if: 1. It is classified as being in default by Standard & Poors (S&Ps) , OR 2. It receives a large non-concessional IMF loan defined in excess of 100 percent of quota. A variety of crises:
1. S&Ps default: two groups depending on the restructuring case (Pre-emptive and post-default) 2. IMF loans: two groups depending on the vulnerability of public sector (i.e., risk of default of sovereign bonds).

Sovereign Debt Crises

SOVEREIGN DEBT CRISES

DEFAULT (S&P's definition)

IMF large package

Sovereign Risk Countries

Public Bonds Vulnerabilities (PBV) Mexico (Feb 1995)* Brazil (Dec. 1998)* Turkey (Dec. 2000)* Brazil (August 2001)

Pre-emptive Ukraine (Sept. 1998)* Pakistan (Jan. 1999) Uruguay (May 2003)* Dom. Rep. (Feb. 2005)*

Post default Russia (August 1998)* Ecuador (Sept. 1999) Argentina (Nov. 2001)*

No PBV Indonesia (Nov. 1997)* Thailand (Aug.1997)*

Note: * denotes countries that experienced also a currency crisis during the 12 months prior and following the sovereign debt crisis. See next section for the definition of currency crises.
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Hypothesis
Efficiency of the sovereign bond market Market inefficiencies can arise when information is often asymmetrically held by market participants.

In order to test market inefficiency in the emerging sovereign bond market, the null hypotheses used are the following: Hypothesis 1: Prior to sovereign debt crises, investors are not perfectly informed on the quality of the sovereign bonds issued by risk countries. By contrast, investment banks observed this risk before the onset of crises. Hypothesis 2: This asymmetric information is above all present in sovereign risk countries exposed with high public finances difficulties.
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Hypothesis
Efficiency of the sovereign bond market
These hypotheses are validated when : H1: Prior to sovereign bond crises investment banks demand a high underwriting fee for bad countries with respect to the sovereign bond spread priced by investors for these countries. H2: By differentiating among sovereign debt crises, we note this effect is above all existent on countries that present sovereign risk difficulties.

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Stylized Facts
Fees and Sovereign Bond Spreads during Crises (Annual Basis)
Fee vs. Primary Sovereign Bond Spread (T is the crisis entry)
1 ,2 1 ,1 1 0,9 0,8 0,7 0,6 0,5 0,4 0,3 0,2
T-3 T-2 T-1 T T+1 T+2 T+3 Fee Average (% ) Primary Sovereign Bond Spread Average (bp; rhs)

Fee vs. Secondary Sovereign Bond Spread (T is the crisis entry)

1 ,2
600

Fee Average (% ) Secondary Sovereign Bond Spread Average (bp; rhs)

1 800 1 600 1 400 1 200 1 000 800 600 400

T-3 T-2 T-1 T T+1 T+2 T+3

1 ,1
550

1 0,9

500

0,8 0,7 0,6

450

400

0,5 0,4 0,3

350

300

0,2

Source: The author based on Dealogic, 2007

Source: The author based on Dealogic and Datasteram, 2007

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Stylized Facts
Fees and Sovereign Bond Spreads during different types of Crises
Fee vs. Sovereign Bond Spreads Post default and IMF Package Public Bonds Vul. cases (T is the crisis entry) Fee Average (% )
1 ,8 1 ,6 1 ,4 1 ,2 1 0,8 0,6 0,4 0,2 0
T-3 T-2 T-1 T T+1 T+2 T+3 Primary Sovereign Bond Spread Average (bp; rhs) Secondary Sovereign Bond Spread Average (bp; rhs)

Fee vs. Sovereign Bond Spreads Pre-emptive and IMF Package No Public Bonds Vul. Fee Average (% ) Cases (T is the crisis entry)
1 ,8

1 900 1 700 1 500 1 300 1 00 1 900 700 500 300

1 ,6 1 ,4 1 ,2 1

Primary Sovereign Bond Spread Average (bp; rhs) Secondary Sovereign Bond Spread Average (bp; rhs)

1 500 1 300 1 00 1 900 700

0,8 0,6 0,4 0,2 0

T-3 T-2 T-1 T T+1 T+2 T+3

500 300 1 00 -1 00

Source: The author based on Dealogic and Datasteram, 2007

Source: The author based on Dealogic and Datasteram, 2007

Sovereign Risk Countries

No Sovereign Risk Countries

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Stylized Facts
Underwriting and Primary Sovereign Bond Spreads 1993-2006 (Annual basis)
Fee (%)
1,8
B ra zil( T - 1) T urk e y( T - 3 )

1,6
A rg.( T - 3 )

1,4 1,2
Urug. A rg. A rg.( T - 1) P hilip. R us .( T - 1) R us .( T - 2 ) Turkey Leb. Leb. Ven. Leb.

A rg.( T - 2 )

Rus. Co l. T urk e y( T - 1) Ven.

1 0,8 0,6 0,4 0,2 0 0

A rg.

P hilip.Ven. M ex. P an. P hilip. A rg. A rg. Turkey P an. T urk e y( T - 2 ) M P oHung. Co l. Leb. x.( T - 2 ) l. Urug. e Turkey M ex. P hilip. Turkey M ex. Co l. Co l. MLeb. ex. Leb. Urug. P ak. an. P Ecu. B razil S.A frica B razil Thai. Ind. Viet. Co l. P an. Ven. Urug. China P o l. A rg. M ex. Ven. Urug.an. P frica S.A A rg. B razil P eru M ex. B ul. B ul.razil B M ex. Urug. M al. S.A P an. S.A frica B ra zil( T - 2 ) fricaEl Sal. S.A frica Do m.Rep. Co l. razil Uk. B China M ex. ChinaEgypt Leb. P an. Urug. hilip. P El Sal. Co M ex. l. Leb. China M al. P an. China China P o l. Chile M o r. M al. M o r.Chile Co l. China Co l. China M ex. P an. B razil Urug. P ak. B razil P o l. Chile P eru Peru Hung.Chile S.AP o l. S.A frica frica P hilip. P eru Hung. Urug. El Sal. Thai. P o l. M ex. Turkey China Ind. Hung. o l.P o l. P Turkey Ind. P hilip. Turkey P hilip. Leb. Hung. Hung. P hilip. Leb. P hilip.

China

Co l. S.A frica Urug. El Sal. Urug.

Co l. B razil Turkey Turkey Co l. Ven. Turkey B razil Ven.

100

200

300

400

500

600

700

800

900

Primary Bond Spread (bp.)

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Econometric analysis
feeit 1 2 SBSit 3 crisisit 4 SBScrisisit 5 Ti it
where period t, SBS it is the sovereign bond spread (i.e., primary or secondary bond spreads) and it is taken in basis points (bp) crisisit is a dummy variable that takes the value of 1 for countries placed prior to the onset of a sovereign debt crisis (between T-3 and T-1) and 0 otherwise. SBScrisisit is defined as the product of SBS and crisis Ti is a time dummy variable.

fee it is the underwriting spread received by investment banks from country i in

OLS and Fixed Time Effect estimation

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Econometric analysis
Undewriting Fee, Primary Sovereign Bond Spread and Soveregn Debt Crisis
Dependent variable: Fee

(1993 - 2006) Annual Data

I II III IV V VI VII VIII IX
0.000342*** 0.000257** 0.000289** 0.000343*** 0.000356*** 0.000219* 0.000274** 0.000264** 0.000280** (2.65) (2.12) (2.30) (2.65) (2.72) (1.84) (2.27) (2.31) (2.40) 0.35750*** 0.52239*** (5.25) (2.78) 0.01504 0.23692 (0.10) (0.75) 0.44217*** 0.94235*** (5.92) (3.83) 0.57120*** 0.75583*** (6.92) (2.86) - 0.00043 - 0.00083 - 0.00121** - 0.00048 (-0.94) (-0.80) (2.13) (-0.74) 0.45246*** 0.43965*** 0.42969*** 0.45192*** 0.44771*** 0.45241*** 0.43558*** 0.44014*** 0.43538*** (9.64) (10.07) (9.56) (9.54) (9.38) (10.57) (10.11) (10.59) (10.34) 170 170 170 0.1659 170 0.0288 170 0.0267 170 0.1974 170 0.2141 170 0.2449 170 0.2429

Primary Sovereign Bond Spread (SBS ) Sovereign Debt Crises (crisis ) No Public Bond Difficulties (crisis ) Public Bond Difficulties (crisis ) Public Bond Difficulties and Currency crises (crisis ) Interactive dummy (SBScrisis ) Cons

N (Observations)

Adjusted R-squared 0.0345 0.1665 t-statistics are in parentheses denoting *** 1%, ** 5% and * 10% significance.

1. An increase of 100 bp of the bond spread only implies an increase of 0,03 per cent of the underwriting fee. 2. H1: On average prior to crisis, countries paid 0,52 per cent of extra fee. This variable is statistically significant at 1 per cent. 3. H2: When we take into account ONLY sovereign risk countries, the fixed cost that these countries have to pay to investment banks is high (0,94 per cent of the proceeds).
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Econometric analysis
Undewriting Fee, Primary Sovereign Bond Spread and Soveregn Debt Crisis
Dependent variable: Fee

(1993 - 2006) Annual Data

I II III IV V VI VII VIII IX
0.000369** (4.47) 0.000432*** 0.00039*** 0.000409*** 0.000432*** 0.000434*** 0.000363*** 0.000391*** 0.00037** (4.80) (4.43) (4.52) (4.76) (4.75) (4.12) (4.43) (4.53) 0.16648*** 0.27861*** (3.41) (2.07) -0.00047 0.04411 (-0.00) (0.21) 0.21430*** 0.55234*** (3.92) (3.09) 0.35271*** (6.14) - 0.00029 - 0.000167 - 0.00082** (-0.90) (-0.24) (-1.99) -0.9252 -0.07063 -0.06250 -0.09253 -0.09244 -0.06503 -0.03976 -0.04496 (-0.90) (-0.71) (-0.62) (-0.90) (-0.89) (-0.66) (-0.40) (-0.48) 0.05713 0.07884 0.08710 0.05713 0.05723 0.08433 0.10972 0.10443 (0.51) (0.72) (0.79) (0.51) (0.50) (0.78) (1.02) (1.03) -0.04233 -0.06515 -0.06891 -0.04230 -0.04477 -0.05266 -0.04397 -0.05786 (-0.45) (-0.72) (-0.76) (-0.45) (-0.47) (-0.59) (-0.50) (-0.69) 0.12083 0.09848 0.10391 0.12082 0.12091 0.09144 0.10221 0.09809 (1.37) (1.15) (1.21) (1.37) (1.36) (1.08) (1.22) (1.24) -0.08482 -0.09683 -0.08744 -0.08482 -0.08509 -0.09817 -0.07146 -0.08453 (-0.92) (-1.08) (-0.97) (-0.92) (-0.92) (-1.11) (-0.81) (-1.02) -0.19399** -0.19972** -0.18354** -0.1940** -0.19417** -0.20** -0.15432** -0.18498** (-2.19) (-2.33) (-2.10) (-2.19) (-2.18) (-2.36) (-1.78) (-2.33) -0.18536** -0.19484** -0.18598** -0.18533** -0.18568** -0.18138** -0.14753** -0.15657** (-2.08) (-2.26) (-2.14) (-2.06) (-2.06) (-2.12) (-1.71) (-1.95) -0.39163*** -0.37188*** -0.36895*** -0.39160*** -0.39221*** -0.35394*** -0.33286*** -0.33485*** (-4.61) (-4.51) (-4.47) (-4.58) (-4.57) (-4.32) (-4.07) (-4.35) -0.39932*** -0.38363*** -0.37610*** -0.39928*** -0.39633*** -0.35917*** -0.33910*** -0.34031*** (-4.32) (-4.29) (-4.18) (-4.29) (-4.21) (-4.04) (-3.82) (-4.07) -0.52629*** -0.49944*** -0.49357*** -0.52630*** -0.52643*** -0.49063*** -0.46871*** -0.47134*** (-5.96) (-5.82) (-5.73) (-5.94) (-5.92) (-5.77) (-5.52) (-5.90) -0.55142*** -0.52708*** -0.52006*** -0.55142*** -0.55144*** -0.51988*** -0.49627*** -0.50020*** (-6.26) (-6.16) (-6.05) (-6.24) (-6.22) (-6.14) (-5.86) (-6.28) -0.55111*** -0.5280*** -0.52042*** -0.55111*** -0.55110*** -0.52160*** -0.49716*** -0.50172*** (-6.11) (-6.03) (-5.91) (-6.09) (-6.07) (-6.02) (-5.73) (-6.16) -0.57220*** -0.55153*** -0.54283*** -0.57220*** -0.57206*** -0.54671*** -0.52062*** -0.52645*** (-5.89) (-5.85) (-5.73) (-5.87) (-5.85) (-5.87) (-5.58) (-6.00) 0.69821*** 0.68617*** 0.67354*** 0.69822*** 0.69767*** 0.68696*** 0.65501*** 0.66533*** (9.07) (9.21) (8.87) (9.04) (9.00) (9.32) (8.76) (9.59) 170 170 170 0.6234 170 0.5954 170 0.5929 170 0.6320 170 0.6390 170 0.6750

Primary Sovereign Bond Spread (SBS ) Sovereign Debt Crises (crisis ) No Public Bond Difficulties (crisis ) Public Bond Difficulties (crisis ) Public Bond Difficulties and Currency crises (crisis ) Interactive dummy (SBScrisis ) Year 1994 (T ) Year 1995 (T ) Year 1996 (T ) Year 1997 (T ) Year 1998 (T ) Year 1999 (T ) Year 2000 (T ) Year 2001 (T ) Year 2002 (T ) Year 2003 (T ) Year 2004 (T ) Year 2005 (T ) Year 2006 (T ) Cons

0.34053* (1.84) 0.00003 (0.07) -0.04580 (-0.49) 0.10360 (1.01) -0.05822 (-0.69) 0.09776 (1.23) -0.08567 (-1.01) -0.18644** (-2.26) -0.15747* (-1.93) -0.33558*** (-4.31) -0.34102*** (-4.04) -0.47209*** (-5.84) -0.50099*** (-6.21) -0.50253*** (-6.08) -0.52730*** (-5.94) 0.66631*** (9.38) 170 0.6729

N (Observations)

Adjusted R-squared 0.5980 0.6238 t-statistics are in parentheses denoting *** 1%, ** 5% and * 10% significance.

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1. Availability of this information:

Bloomberg and Dealogic

Fee and financial markets actors

However it is not accessible at the day of the issue:

According to a member team of Dealogic at the end of 2007 for about 80 % of large deals (more than US$200m equivalent) we should have the fee within 1 day.

Impact on secondary market prices

2. Do investors concern themselves with underwriting fees? Questionnaire to investors in Wall Street
(Alliance Bernstein, Alliance Capital, Fidelity, GE Asset Management, GMO, Goldman, Invesco and Western Asset) 19

Seven investors of the eight interviewed argue that underwriting fee is of no concern in investment decisions. Moreover they do not perceive underwriting fee as a good indicator of credit risk. 3. Investment banks publications on emerging sovereign bond markets. 12 investment banks covering the period 1997-2007 ABN AMRO,
Barclays Capital, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Dresdner Kleinwort Wasserstein, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch and Morgan Stanley.

Fee and financial markets actors

Underwriting fee is not a piece of information given by investment banks to institutional investors.
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Fee and financial markets actors

4. Why, therefore, do investors not pay attention to the evolution of underwriting fees? This is puzzling in that useful, publicly available information is not tracked by investors to help improve allocation of their emerging market fixed income assets.

21

Conclusions
1. investment banks price sovereign default risk well before crises and even before investors. This result suggests that investment banks hold an information advantage over investors 2. Investment banks behaviour differs depending on the type of sovereign debt crisis. Before crises investment banks charged a higher underwriting fee to countries presenting public bond vulnerabilities with respect to other sovereign crises. 3. There is a puzzle in that it appears that investors are not using potentially useful (and public) information in order to allocate efficiently their portfolios.
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