Sovereign Bonds Since Waterloo

The paper asks a question the sovereign debt literature has mostly approached from the borrower’s side: given how often governments default, why do investors keep buying their bonds? It answers by measuring what creditors actually earned, assembling two new datasets and matching them bond by bond. The first is monthly price quotations for 1,552 foreign-currency sovereign bonds issued and traded in London and New York between 1815 and 2016 – 266,134 observations covering up to 91 countries in an unbalanced panel. The second is an archive of external default and restructuring events built largely from the annual reports of nineteenth- and early-twentieth-century bondholder organisations, yielding haircut estimates for 313 restructuring events in 91 countries and, crucially, the timing and size of missed or partial coupon payments at monthly frequency. The central finding is that the average real ex-post yearly return on a global portfolio of external sovereign bonds was 6.85% – about 4 percentage points above the “risk-free” benchmark of long-term UK and US government bonds, with the excess return running 2% to 4% depending on the era. Two things make that survive the defaults. First, defaults do not wipe creditors out: the average haircut is 44% (39% when weighted by amount restructured), with a standard deviation of about 30% and no visible time trend across 200 years, and outright repudiation is confined to revolutions and imperial break-ups. Second, roughly 70% of the 8.0% average nominal return – 5.6 percentage points – comes from coupons rather than capital gains, so returns keep accruing even while prices are depressed. The risk is real and priced: bonds of the 51 “serial defaulters” earn the highest returns (7.1% real, 4.6% excess) and also the highest volatility; after a default the cumulative return index falls about 15%, and an investor entering two years before default breaks even about four years after it, though the lower quartile of episodes never recovers within six years. Compared with other asset classes over the same two centuries, only US equities and a 16-country advanced-economy equity portfolio returned more, while the external sovereign bond portfolio’s Sharpe ratio is on a par with US equities and above US corporate bonds, UK equities, and domestic sovereign bonds. The authors are explicit about the scope limits: the sample is unbalanced with a near-total gap in the 1970s and 1980s syndicated-bank-loan era, so the 1980s debt crisis is largely absent; and they caution that the unusually good modern performance should not be read as a “new normal.”

Josefin Meyer | Macro Paper Warehouse

Sovereign Bonds Since Waterloo