Forecasting Sovereign Credit Spreads

Abstract

This article presents an econometric model to detect whether emerging market sovereign bonds are trading cheap or expensive. The model is based on the notions that in the long run the equilibrium spread ratio between different sovereigns is essentially a function of relative credit ratings and a set of more rapidly changing relevant variables, but both market and economic shocks can temporarily disturb these relations. Its empirical evaluation is based on cointegration using six years of data for the ten largest emerging market sovereign creditors. Under a parsimonious specification, the estimates provide reasonable values for all critical coefficients. Simulations using out-of-sample forecasts show that trading rules based on the model produce excess returns in most countries.