Risk premia in long-duration sovereign bonds

Nicola Borri

No 1501, Working Papers CASMEF from Dipartimento di Economia e Finanza, LUISS Guido Carli

Abstract: In this paper I develop a model of sovereign lending with default and long-duration coupon bonds. Long-duration bonds offer an insurance benefit to the borrower because countries are not required to frequently roll-over outstanding debt. However, investors anticipate that countries might default in the future and ask for returns that compensate for this risk. In this framework, I find that bonds with longer duration offer higher interest rate spreads. Bonds issued by countries that are more likely to receive negative income shocks when investors’ consumption is low have significantly higher interest rate spreads because investors anticipate defaults many periods into the future. Creation-Date: 2015

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