Pricing Sovereign Debt: Foreign versus Local Parameters

• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/eufm.12161
• Author: Michael Bradley,Mitu Gulati,Irving Arturo de Lira Salvatierra,Elisabeth de Fontenay
• Date: 01 March 2018

DOI: 10.1111/eufm.12161

ORIGINAL ARTICLE

Pricing Sovereign Debt: Foreign versus Local

Parameters

Michael Bradley

1

|

Elisabeth de Fontenay

2

|

Irving Arturo de Lira Salvatierra

3

|

Mitu Gulati

2

1

Fuqua School of Business & School of

Law, Duke University, Durham, NC,

USA

Email: bradley@duke.edu

2

Duke University School of Law,

Durham, NC, USA

Emails: gulati@law.duke.edu;

defontenay@law.duke.edu

3

Economics Department, Duke

University

Email: irvingdelir@gmail.com

Abstract

Sovereign bonds may be issued under either local or foreign

parameters. This decision involves a tradeoff between the

sovereign retaining discretion in managing the issue and

relinquishing control to third parties. Examining three key

bond parameters −governing law, currency, and stock

exchange listing −we find that investors generally consider

foreign-parameter debt to be less risky than comparable

local-parameter debt issued by same sovereign. By

matching the foreign- and local-parameter bonds of

sovereigns that have issued both, we find that, with few

exceptions, both investment grade and non-investment

grade sovereigns are able to issue their foreign-parameter

bonds at relatively lower yields.

KEYWORDS

contracts, asset pricing, bonds, sovereign debt, currency risk, governing

law

JEL CLASSIFICATION

F33, F34, G15, K12

The authors are grateful to John Doukas (Editor) and two anonymous referees for their very helpful comments and

suggestions. Thanks for comments are also due to Lee Buchheit, Anna Gelpern, Christoph Trebesch, Mark Weidemaier and

Jeromin Zettelmeyer. The authors owe a special debt to Ugo Panizza and Paolo Colla, who not only provided comments

but helped locate crucial data.

Eur Financ Manag. 2018;24:261–297. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

|

261

1

|

INTRODUCTION

The threshold question faced by any sovereign seeking to raise funds in the bond market is whether to

issue the debt under local or foreign parameters. This choice then determines a number of other key

characteristics of any bond issue such as which underwriters, lawyers, and ultimately investors are

likely to be involved. Most important, the decision involves a tradeoff between the sovereign retaining

control of the issue by relying on local parameters or relinquishing a certain degree of control by issuing

under foreign parameters. Beginning with a sample of 111 sovereigns issuing 22,605 bonds from 1990

to 2016, we examine three contractual factors that are the key determinants of where a particular

issuance falls on the local versus foreign continuum: governing law, currency and the stock

exchange(s) on which the issue is listed.

Recent interest in the question of local versus foreign parameters has been largely motivated by the

restructuring of the debt of Greece in 2012. In March of 2012, Greece conducted one of the most severe

sovereign debt restructurings ever, forcing the majority of its creditors to take haircuts in the range of

60–75% of the net present value promised by the issue. Greece was able do this without going into legal

default because it took advantage of the fact that over 90% of its outstanding bonds were governed by

local Greek law. This allowed the Greek legislature to pass a law retroactively inserting in its local-law

debt contracts a provision (formally a ‘retrofit collective action clause’) that facilitated the dramatic

restructuring. In contrast, the terms of Greece's foreign-law-governed bonds could not be altered by

Greek legislative fiat, and holders of these bonds who held out during the restructuring were paid in full

and on time.

1

Others have argued, however, that because it is more likely to be held by domestic voters

or systemically important domestic institutions such as banks, debt issued under local parameters

might, under some circumstances, be harder to restructure (and therefore safer) than debt issued under

foreign parameters (Borensztein, Levy Yeyati, & Panizza, 2006; Guembel & Sussman, 2009). Whether

investors view local or foreign debt as a safer investment remains an open question.

The empirical research on the relative pricing of lo cal versus foreign parame terized bonds is

relatively sparse. Such stu dies have tended to focus exclusively on either currenc y or governing law

alone, have generally been rel atively narrow in scope (focus ing, for example, on the eurozone debt

crisis of 2010–13), and have foc used on price movements during periods of financial di stress, rather

than on pricing at issuance. Building on the facts of the Greek restructur ing, for example, a number

of researchers have examined w hether investors who held bonds go verned by foreign law fared

better than those who held bonds governed by domestic law as the euro area crisis worsen ed during

the 2010–13 period.

Consequently, these studies examine a small number of sovereigns nearing financial distress, over

a relatively short period of time and denominated in a single currency (the euro) (Choi & Gulati, 2016;

Schumacher, Chamon, & Trebesch, 2015; Clare & Schmidlin, 2014; Nordvig, 2015). For example,

Schumacher et al. study 100 bonds of 8 sovereigns over the period 2007 to 2014; Clare and Schmidlin

study a sample of 400 bonds from 2008 through 2012; and Nordvig examines 137 pairs of bonds issued

by 7 sovereigns from 2009 to 2014. The general conclusion to be drawn from this literature is that

1

For details regarding the Greek restructuring, see Zettelmeyer, Trebesch, and Gulati (2013) and Schumacher, Chamon, and

Trebesch (2015). Greece was not the first sovereign to have taken advantage of its control over local law to significantly

reduce its financial obligations, nor will it be the last. In 1998, Russia imposed large haircuts on domestic-law bonds in

order to avoid a full-scale default. Its bonds governed by foreign law were untouched (Duffie, Pedersen, & Singleton, 2003;

Gelpern, 2017). The same occurred with Jamaica in 2000 (Erce & Diaz-Cassou, 2010). During the Great Depression of the

1930s, the US government used its control over the governing law to engineer a transfer of value from creditors to debtors

by legislatively abrogating the gold clauses in all domestic debt contracts (Kroszner, 1998).

262

|

BRADLEY ET AL.

investors who held bonds governed by foreign law fared significantly better than those investors who

held bonds governed by domestic law.

In this article, we take a broader view of the question by looking at a fuller set of salient local and

foreign parameters in the typical bond, doing so over a quarter century of data for the entire global

market, and comparing bonds issued in different currencies. Our contribution to the literature on

sovereign debt is threefold. First, we examine a much larger sample in terms of the number of

sovereigns, the number of bonds, the number of bonds per sovereign and the time period covered than

appears in the existing literature. Second, we focus on when-issued prices as opposed to prices in the

secondary market. Relying on pricing at issuance allows us to measure how investors price local-

versus foreign-parameter debt ex ante—that is, prior to any eminent threat of financial distress. Third,

we examine several parameters simultaneously as opposed to examining only one parameter in

isolation. More broadly, and beyond the sovereign debt literature, we believe we have made a

contribution to the literature on the price impact of bond covenant provisions (e.g., Bradley & Roberts,

2015; Eichengreen & Mody, 2004).

As illustrated by the Greek experience, having its debt governed by local law gives a sovereign

debtor leeway in restructuring its debt in times of a crisis. A similarly powerful weapon is having the

debt denominated in local currency. As an historical matter, several governments in financial crisis

have exploited the fact that their debt was denominated in domestic currency and increased their money

supply in order to inflate their way out of their debt obligations (Gelpern, 2017; Reinhart & Rogoff,

2009 and 2011). If interest rate parity holds, there should be no difference in pricing between foreign-

currency and local-currency debt, after adjusting for expected inflation. Yet the interest rate parity

relation assumes no difference in credit risk. The question is thus how credit risk is affected by whether

the sovereign controls the currency in which the bonds are denominated.

Research on a sovereign's choice to denominate its debt in local or foreign currency has largely

focused on the fact that, until recently, many emerging market issuers have not been able to borrow in

anything but foreign currencies (Eichengreen, Hausmann, & Panizza, 2005). Another strand of the

literature focuses on the choice of foreign- or local-currency debt primarily from the sovereign's

perspective, weighing the numerous tradeoffs involved in selecting its aggregate debt mix (see Panizza,

2008 for an overview). Incorporating the investor perspective, there is some research indicating that

yields on domestic currency bonds are higher than those denominated in foreign currencies, but this

research has focused only on emerging market issuers and their choice of currency (see Gadanecz,

Miyajima, & Shu, 2014, for a review of this literature).

A third factor that may give a sovereign breathing room in times of crisis is having its bonds listed

on a local rather than a foreign stock exchange. Stock exchanges are the primary regulators of the

sovereign debt market and dictate the periodic disclosures that debtors must make to investors. Leeway

from the exchange in terms of what information the sovereign has to disclose and when it must be

disclosed could help buy the sovereign valuable time during a crisis. As best we are aware, however,

there is no research examining the pricing impact of foreign versus local listing in the sovereign debt

market. A related literature in the corporate area finds that firms’stock prices increase when they list

their stock in a foreign jurisdiction with stronger disclosure and investor protection requirements such

as the US (Doidge, Karolyi, & Stulz, 2004). One proposed rationale is that subjecting the firm to the

stricter listing and reporting requirements of the SEC and US exchanges can reduce the ability of

management to expropriate wealth from its stockholders (Karolyi, 2006; Witmer, 2006).

One might therefore presume that creditors would always prefer that sovereigns denominate their

bonds in foreign currencies, have them governed under foreign law, and list them on a foreign stock

exchange. After all, local-parameter debt gives the issuing sovereign a ‘home field’advantage in any

disputes with its investors. This is particularly true if the sovereign experiences financial difficulties

BRADLEY ET AL.

|

263