Conditional spread determinants for emerging sovereign debt

This paper addresses conditional sovereign credit risk determinants. In our model, the spread determinants' magnitude is conditional on an unobservable endogenous sovereign credit cycle as represented by the underlying state of a Markov regime switching process. Our explanatory variables are motivated in the tradition of structural credit risk models and include changes in asset price, interest rate, volatility and foreign exchange variables. We examine daily frequency variations of U.S. dollar denominated Eurobond credit spreads of four major Latin American sovereign issuers with liquid bond markets. We nd that spread determinants are statistically signi cant and consistent with theory while their magnitude varies with the states of our cycle variable, which characterizes low and high spread change uncertainty.We also uncover the presence of additional premium under Regime 1 where the spread volatility is stable. This premium is negatively related to the changes in credit spreads. The term structure factors exhibit much higher economic magnitudes under the high volatility sate. The response from the asset price factor to changes in credit spread is rather stable. We document that not only changes of local currencies, but also changes of the Euro with respect to the U.S. dollar are signi cant spread drivers and show that this is consistent with the sovereigns ability to meet its obligations.