Essays on Sovereign Bond Markets

Abstract

This dissertation comprises three chapters investigating the impact of informa- tion frictions and market segmentation on debt financing in a small open economy.In the first chapter, I examine debt crises in countries relying on bond auctions to finance outstanding debt. Using a noisy rational expectation model, I show that information frictions can trigger debt crises even when fundamentals alone wouldn’t. Pessimistic signals can lead to defaults with low default risk fundamentals, while optimistic signals can avert defaults with high default risk fundamentals. The second and third chapters study sovereign credit ratings’ implications for developing countries. I explore the impact of market segmentation from ratings on default risk and borrowing behavior. Using emerging market panel data, I estimate bond spread responses to downgrades to junk rating, emphasizing regulatory thresh- olds. The third chapter introduces a quantitative sovereign default model incorporat- ing credit ratings and segmented markets. I find higher spreads imply a 200-basis- point higher discount rate on junk bonds. Beyond a threshold, downgrades lead to higher interest rates, reducing default risk and raising bond prices. Segmentation benefits low-debt states, mitigating overborrowing friction and providing welfare gains. A looser rating rule diminishes these gains.