DP16474 Selective Default Expectations

Author(s): Olivier Accominotti, Thilo Albers, Kim Oosterlinck
Publication Date: August 2021
Keyword(s): creditor discrimination, Debt default, secondary markets, sovereign risk
JEL(s): F13, F34, G12, G15, H63, N24, N44
Programme Areas: Financial Economics, Economic History, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16474

Sovereign governments often discriminate between creditors during debt default episodes. This paper explores how expectations of selective default affect sovereign bond trading and sovereign risk premia based on a historical laboratory: the German external default of the 1930s. We exploit a unique feature of the interwar sovereign bond market: identical German government bonds were traded on different creditor countries' secondary debt markets but investors expected creditors from various countries to be treated differently in case of default. We show that, when creditor countries' secondary debt markets are integrated, selective default expectations are not reflected in bond yields but affect the volume of bonds traded across markets. By contrast, when creditors' debt markets are geographically segmented, a large selective risk premium can be priced in sovereign bonds. This premium accounted for up to half of the total risk premium on German external bonds during the 1930s. We establish that creditor countries' seniority ranks can be explained by their economic power over the debtor government.