Exodus from Sovereign Risk: Global Asset and Information Networks in the Pricing of Corporate Credit Risk

• Author: JONGSUB LEE,ANDY NARANJO,STACE SIRMANS
• Date: 01 August 2016
• DOI: http://doi.org/10.1111/jofi.12412
• Published date: 01 August 2016

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 4 •AUGUST 2016

Exodus from Sovereign Risk: Global Asset and

Information Networks in the Pricing

of Corporate Credit Risk

JONGSUB LEE, ANDY NARANJO, and STACE SIRMANS∗

ABSTRACT

Using five-year credit default swap (CDS) spreads on 2,364 companies in 54 countries

from 2004 to 2011, we find that firms exposed to stronger property rights through their

foreign asset positions (institutional channel) and firms cross-listed on exchanges with

stricter disclosure requirements (informational channel) reduce their CDS spreads by

40 bps for a one-standard-deviation increase in their exposure to the two channels.

These channels capture effects beyond those associated with firm- and country-level

fundamentals. Overall, we find that firm-level global asset and information connec-

tions are important mechanisms to delink firms from their sovereign and country

risks.

TO WHAT EXTENT CAN PRIVATE SECTOR firms delink themselves from sovereign

risk? It is well known that while governments play an important role in finan-

cial markets, they can also generate externalities arising from their actions

and their ability to compel and proscribe. For example, governments suffering

from large budget deficits and slow economic growth may limit the ability of

private sector firms to service their external debt obligations. Budget deficits

may also presage increases in corporate taxes or other corporate infringements,

increasing potential default risks.1In the aftermath of the recent global credit

risk crisis, where sovereign credit default swap (CDS) spreads rose dramati-

cally from an average of 30 bps to above 250 bps in 2008 and remained above

100 bps thereafter (see Figure 1), there is increasing concern about the trans-

fer of sovereign risk to private sector firms. Anecdotal evidence suggests that

∗Jongsub Lee and Andy Naranjo are at the University of Florida. Stace Sirmans is at the

University of Arkansas. We thank Viral Acharya, David T. Brown, Mark Flannery,Xavier Giroud,

Francis Longstaff, David Marcus, Jay Ritter, Ken Singleton (the Editor), Daniel Sokol, Marti

Subrahmanyam, Charles Tabb, Dragon Tang, Hayong Yun, an anonymous Associate Editor, and

two referees for helpful comments and suggestions. We also thank both the Heritage Foundation,

particularly Anthony B. Kim, and the Credit Research group at Markit led by Gavan Nolan for

their data support. This study benefited from the many insightful comments from discussants and

participants at the 2013 SFS Finance Cavalcade (Miami), the 2013 WU Gutmann Symposium

(Vienna), and the 2013 China International Conference in Finance (Shanghai). Jaeyung Kim

and Jerry Singh provided excellent research assistance. We have read the Journal of Finance’s

disclosure policy and have no conflicts of interest to disclose.

1See, for example, Ernst and Young, “Global Tax Policy and Controversy Briefing (January,

2012).”

DOI: 10.1111/jofi.12412

1813

1814 The Journal of Finance R

Figure 1. Global sovereign CDS spreads. This figure presents the time series of the GDP-

weighted and equally weighted mean of global five-year sovereign CDS daily spreads (in basis

points) of 54 countries over the period 2004 to 2011. CDS data are provided by Markit. Numbers

are placed on the graph to mark important events, highlighting the initial increase in credit

risk in the financial sector, the government bailouts that followed, and the increase in sovereign

credit risk across the globe. For a more complete timeline of the recent financial crisis, visit

http://timeline.stlouisfed.org.

1. July 31, 2007. Bear Stearns liquidates hedge funds.

2. September 15, 2008. Lehman Brothers files for Ch. 11 bankruptcy.

3. October 3, 2008. U.S. Congress passes Troubled Asset Relief Fund (TARP).

4. December 16, 2009. S&P cuts Greece’s credit rating.

5. April 27–28, 2010. S&P cuts the credit ratings of Greece, Portugal, and Spain.

6. May 2–9, 2010. Greece accepts bailout; European Financial Stability Facility (EFSF) created.

7. November 28, 2010. Spain accepts bailout.

8. May 17, 2011. Portugal accepts bailout.

9. September 18–October 13, 2011. S&P cuts the credit ratings of Spain, Italy,and 24 Italian banks.

such concerns are warranted, as governments such as Argentina have turned

toward interventionist economic policies such as expropriation and foreign ex-

change, trade, and capital controls.2In addition to this sovereign (intervention)

risk, firms and investors are also potentially exposed to other location-driven

country risks, which include legal and enforceability problems, corruption, and

political instability.3

2See, for example, Wall Street Journal, “Argentina to Seize Control of Oil Firm” (M. Moffett and

T. Turner, April 17, 2012) and “Dollars Become Scarce as Argentina Cries Peso” (M. Moffett, June

13, 2012). See also Bloomberg, “Porsche Sells Malbec to Keep Autos Coming into Argentina: Cars”

(E. Raszewski, November 2, 2011).

3Major credit rating agencies note the distinction between sovereign risk and country risk.

However, the ratings agencies acknowledge that these risks are frequently correlated, in part

Exodus from Sovereign Risk 1815

In this paper, we propose two novel institutional and informational chan-

nels through which private sector firms can delink themselves at least in part

from sovereign risk as well as country risk. Using five-year CDS spreads on

2,364 companies in 54 countries over the period 2004 to 2011, we show that

firms exposed to stronger property rights institutions through their foreign

asset positions (institutional channel) and firms whose stocks are listed on ex-

changes with stricter disclosure requirements (informational channel) reduce

their CDS spreads by 40 bps for a one-standard-deviation increase in their ex-

posures to the two channels. Our reported effects exist beyond those associated

with firm- and sovereign-level fundamentals, country fixed effects, and credit

rating effects. We further show that our results are robust to extensive robust-

ness checks, including potential specification, identification, and endogeneity

concerns. Overall, our results highlight that firm-level global asset and in-

formation network connections are important mechanisms for delinking firms

from sovereign and country risks.

Our study contributes to three important streams of research. First, we

contribute to the literature on multinational corporate credit risk. Our in-

ternational CDS data and information on both firm- and sovereign-level fun-

damentals provide a comprehensive picture of the determinants of corporate

credit risk for 2,364 firms in 54 countries over an eight-year period.4We ex-

tend the credit risk models explored in Collin-Dufresne, Goldstein, and Martin

(2001), Bharath and Shumway (2008), and Campbell, Hilscher, and Szilagyi

(2008) by formally testing a more elaborate credit risk pricing model for multi-

national corporations (MNCs) whose global asset and information networks

play an important role in explaining their borrowing costs. International CDS

markets are an ideal experimental setting to conduct these tests relative to

corporate bond yield spreads and credit ratings because CDS contracts have

standardized contractual terms and are more liquidly traded than the bonds is-

sued by the same entities (Longstaff, Mithal, and Neis (2005)). Moreover, CDS

because the basis of country risk is usually sovereign-related through government inaction and

complicity. Since there are no uniform standards in separately quantifying country risk in their

corporate credit risk modeling (S&P (2013)), credit rating agencies often emphasize in their corpo-

rate credit analysis “transfer and convertibility” (T&C) risk—the risk of exchange controls being

imposed by sovereign authorities that prevent or impede the private sector’s ability to convert

local currency into foreign currency and make their debt service. These sovereign intervention

type risks also broadly include government expropriatory actions such as nationalizing firm assets

or taking actions that restrict the ability of a company to operate. In contrast, country risk often

focuses on a country’s business environment risks, including the legal environment, the level of

corruption, and political stability. For additional details, see “2008 Corporate Criteria: Analytical

Methodology” (Standard & Poors (2008)), “Understanding Ratings above the Sovereign” (Standard

& Poors (2011)), and “Country Risk and Sovereign Risk—Building Clearer Borders” (S&P Capital

IQ (2013)), among others.

4Durbin and Ng (2005) study the determinants of yield spreads on only 108 corporate bonds from

emerging markets, and Peter and Grandes (2005) examine similar issues using bond market data

for nine firms in South Africa. Borensztein, Cowan, and Valenzuela (2013)examinetherelation

between corporate credit ratings and their sovereign counterparts using S&P credit ratings on 509

firms in 30 emerging market countries. Bai and Wei(2012) study a similar topic using international

CDS data from 30 countries over the three-year period 2008 to 2010.