Piercing the Sovereign Ceiling in Credit Default Swap Markets: An Empirical Analysis and Implications for Risk Management

Abstract

Sovereign ceiling violations (SCVs) exist when a firm is able to access better borrowing terms than its sovereign. Generally, the sovereign’s borrowing rate serves as a “ceiling” for the rates of riskier corporates. This paper studies the disproportionate downgrade of SCVs following sovereign downgrades in the CDS markets, and frames this effect as another risk channel for overall deteriorating credit fundamentals in emerging market economies (EMEs). Using a new dataset of CDS spreads and issuer financial information from 2002 to 2016, we investigate this sovereign effect in CDS markets for 13 EMEs across three geographical regions: Asia, Latin America, and Europe. We find that CDS contracts that pierce the sovereign ceiling suffer a larger widening of spreads than comparative contracts that do not after yields of the corresponding sovereign CDS widen. This disproportionate effect is significant even when controlling for differences in issuer fundamentals and CDS contractual terms, which suggests that SCVs may actually have a better credit risk profile than their risk indicators suggest. This effect was particularly strong during the 2008 financial crisis.