News, sovereign debt maturity, and default risk
FRB of St. Louis 2018.12.12
Leading into a debt crisis, interest rate spreads on sovereign debt rise before the economy experiences a decline in productivity, suggesting that news may play an important role in these episodes. The empirical evidence also shows that a news shock has a significantly larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. We develop a quantitative model of news and sovereign debt default with endogenous maturity choice that generates impulse responses very similar to the empirical estimates. The model allows us to interpret the empirical evidence and to identify key parameters. We find that, first, the increase in sovereign yield spreads around a debt crisis episode is due mostly to the lower expected productivity following a bad news shock, and not to the borrowing choices of the government. Second, a shorter debt maturity increases the chance that bad news shocks trigger a debt crisis. Third, an increase in the precision of news allows the government to improve its debt maturity management, especially during periods of high financial stress, and thus face lower spreads and default risk while holding the amount of debt constant.