Default Risk of Sovereign Debt in Central America

This chapter analyses the drivers of sovereign debt default risk for the following Central American countries: Belize, Costa Rica, Guatemala, Honduras, Panama, and El Salvador. Table 2.1 presents the long-term credit ratings of government bonds for these countries by Moody’s, Standard & Poor’s, and Fitch. We use daily data on the yield spread of bonds issued by the governments of these states. Spreads are computed with respect to the fixed income instruments issued by the United States (US) Treasury. We are motivated to use the yield spread variable since it reflects investors’ evaluation about the default probability of sovereign debt. We measure the sensitivity of yield spreads to several global, regional, and country-specific factors. The dynamic econometric models applied in this chapter are new in the literature of default risk analysis. In particular, we use the recent beta-t-EGARCH dynamic volatility model of Harvey and Chakravarty (2008) and Harvey (2013a) combined with the autoregressive (AR) model, to specify the conditional volatility and mean of yield spreads. Moreover, we use a Markov regime switching AR model for the yield spread that identifies high- and low-volatility sub-periods and involves time-dependent effects of default risk factors. To the best of our knowledge, this study is the first in the literature about the determinants of sovereign bond default risk in Central America.