How Sovereign is Sovereign Credit Risk?
by Francis A. Longstaff of the University of California, Los Angeles,
Abstract: The benefits from diversifying equity portfolios internationally are well established in the literature. We study whether diversifying sovereign credit portfolios across countries has similar benefits. The evidence suggests that the benefits are likely to be much smaller for two reasons. First, sovereign credit is more correlated across countries than are equity returns. In fact, just three principal components account for more than 50 percent of the variation in sovereign credit spreads. Furthermore, sovereign credit spreads are more related to the U.S. stock and high-yield bond markets, global risk premia, and international trading and liquidity patterns than they are to local economic measures. Second, we find that excess returns from investing in sovereign credit are largely compensation for bearing global risk. In particular, there is little or no country-specific credit risk premium after adjusting for global risk factors, and a significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.