Categories, Creditworthiness, and Contagion: How Investors' Shortcuts Affect Sovereign Debt Markets

We assess how investors evaluate sovereign borrowers, arguing that sovereign risk is less sovereign than previous research assumes. Investors evaluate governments based not only on what they do, but also on investors' views of similar, peer countries. Professional investors use investment categorizations (geography, sovereign credit rating, or level of market development) as a heuristic device. As a result, peer country effects, as well as country-specific and global factors (booms, crises, or shocks), should explain sovereign interest rates. The peer effects we expect are regular features of international capital markets, rather than phenomena that occur in periods of market turmoil. We assess our expectations using error correction models of monthly sovereign risk premiums, which reveal significant interdependencies in sovereign risk assessments among countries, net of global and domestic predictors. Such contagion emerges principally in the short term, although we also find robust, long-term ties in sovereign risk assessments among countries sharing common regional classifications. Hence, our evidence suggests that professional investors' reliance on country categorizations facilitates the transmission of market sentimentswhich include lower as well as higher risk premiums chargedacross groups of countries, even when countries differ in key measures of creditworthiness. Our analyses highlight the importance of investors' ideas regarding country categorizations; they call into question the efficiency of sovereign debt markets.