Deriving developing country repayment capacity from the market prices of sovereign debt

The market prices of developing countries' debts are imperfect indicators of the countries' payment capacity for three reasons: the concave shape of the debt's payoff structure, the presence of third-party guarantees, and the differences in the terms of various debt claims. Claessens and Pennacchi derive an improved indicator of payment capacity by developing a pricing model - using option valuation techniques - that takes these three factors into account. Applying the model to bonds issued recently by Mexico and Venezuela, they find that the estimated indicator of payment capacity often behaves differently from the raw bond prices themselves, confirming the importance of cleaning the raw prices for these three factors. In order of importance, the benefits of cleaning raw prices come first from correcting for the effects of different terms (such as fixed versus floating interest rates), followed by the value of third-party enhancements and then by the concavity of the payoff structure. They find some evidence that the new indicator of repayment capacity conforms better than the raw prices themselves to generally held beliefs about which variables drive a country's repayment capacity. In particular, they find that variables that are often assumed to be related to payment capacity - such as oil prices and the countries' stock market prices - are more closely (and with the right sign) associated with the new estimated measure of payment capacity than are the secondary market prices of the bonds.