The premia on state-contingent sovereign debt instruments

Summary

Focus

State-contingent debt instruments (SCDIs) have many theoretical benefits. For instance, they reduce interest payment burden in recessions and provide fiscal space when a shock hits the economy. But the use of SCDIs is limited in practice. Despite renewed interest during the Covid-19 pandemic, we know very little about the empirical properties of these instruments.

Contribution

This paper fills this gap in the literature by examining GDP-linked warrants issued by Argentina, Greece and Ukraine. It is the first to document the evolution of the SCDI risk premium over a long period of time and for multiple countries. The aim is to understand how SCDIs differ from plain vanilla bonds in terms of their pricing and volatility. For this purpose, the paper presents a general framework to price SCDIs. It then documents how the premium on SCDIs has evolved in the three country cases. It also develops a simple model to explain the documented properties of this premium.

Findings

The SCDI premium is high and persistent. It averages 12.5%, 4.25% and 6.65% for Argentina, Greece and Ukraine, respectively. The SCDI premium exhibits a procyclical pattern. In other words, it is lower when the economy is in a recession. Finally, the liquidity premium on SCDIs is higher and more volatile than those for plain vanilla bonds. A model in which investors fear ambiguity could explain these patterns. 

Abstract

State-contingent debt instruments such as GDP-linked warrants have garnered attention as a potential tool to help debt-stressed economies smooth repayments over business cycles, yet very few studies of the empirical properties of these instruments exist. This paper develops a general framework to estimate the time-varying risk premium of a state-contingent sovereign debt instrument. Our estimation framework applied to GDP-linked warrants issued by Argentina, Greece, and Ukraine reveals three stylized facts: (i) the risk premium in state-contingent instruments is high and persistent; (ii) the risk premium exhibits a pro-cyclical pattern; and (iii) the liquidity premium is higher and more volatile than that for plain-vanilla government bonds issued by the same sovereign. We then present a model in which investors fear ambiguity and that can account for the cyclical properties of the risk premium.

JEL classification: H63, G13, E44.

Keywords: state-contingent debt instruments, GDP-linked warrants, risk premia, procyclicality.