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Sovereign Debt Maturity Structure Under Asymmetric Information

Apr 2013
Working Paper
12-037
By  Diego Perez
This papers studies the optimal choice of sovereign debt maturity when investors are unaware of the government’s willingness to repay. Under a pooling equilibrium debt can be mispriced relative to the borrower’s true fundamentals and the degree such mispricing can differ with the maturity of debt. Long-term debt becomes less attractive for safe borrowers since it pools more default risk that is not inherent to them. In response, safe borrowers issue low levels of debt with a shorter maturity profile - relative to the optimal choice under perfect information - and risky borrowers mimic the behavior of safe borrowers to preclude the market from identifying their type. In times of financial distress, the mispricing of long-term debt relative to short-term debt becomes stronger which makes borrowers reduce the amount of debt issuance and shorten its maturity profile, a fact that is observed among emerging economies. Under this framework, debt buybacks can be optimal when there is an overestimation of the country’s risk perception in the market that was not present when long-term debt decisions were made.