sovereign debt, pricing contract terms, eurozone crisis, debt crisis, Event of Default
We use a natural experiment thrown up by the Euro area sovereign debt crisis of 2010-2013 to test whether a particular contract term, the option to declare an “Event of Default”, is priced. The right to declare an Event of Default in theory gives value to investors holding sovereign guaranteed private bonds relative to investors directly holding sovereign bonds. We find evidence that the market does price such a term in guaranteed private bonds particularly for sovereigns that are near or enter into default, including in particular Greece. That said, we also find a pricing anomaly. As Greece recovered from the crisis, we expect that the spread between guaranteed private bonds and comparable sovereign bonds to return back to pre crisis levels. Instead, we observe that the spread inverts as guaranteed private bond yields rise much higher than prior to the crisis. We explore different explanations for this pricing puzzle.
Stephen J. Choi & Mitu Gulati, From Pigs to Hogs (May 7, 2014)