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Sovereign Bonds since Waterloo

Journal: Quarterly Journal of Economics

Date: 20220801

Author: Meyer, Josefin; Reinhart, Carmen M.; Trebesch, Christoph

Abstract:
This article studies external sovereign bonds as an asset class. We compile a new database of 266,000 monthly prices of foreign-currency government bonds traded in London and New York between 1815 (the Battle of Waterloo) and 2016, covering up to 91 countries. Our main insight is that, as in equity markets, the returns on external sovereign bonds have been sufficiently high to compensate for risk. Real ex post returns average more than 6% annually across two centuries, including default episodes, major wars, and global crises. This represents an excess return of 3%-4% above US or UK government bonds, which is comparable to stocks and outperforms corporate bonds. Central to this finding are the high average coupons offered on external sovereign bonds. The observed returns are hard to reconcile with canonical theoretical models and the degree of credit risk in this market, as measured by historical default and recovery rates. Based on our archive of more than 300 sovereign debt restructurings since 1815, we show that full repudiation is rare; the median creditor loss (haircut) is below 50%.

Link: Google Scholar

Key Findings

High Historical Returns

Foreign-currency sovereign bonds delivered real returns of 6.85% annually over 200 years (1815-2016), including default episodes and wars

Limited Default Losses

Average haircut in sovereign defaults was 44%, with full repudiation being rare. Most defaults end in negotiated settlements

Strong Risk-Return Profile

Sovereign bonds outperformed most other asset classes, with excess returns of 3-4% above UK/US government bonds

Historical Returns Across Asset Classes

  • External sovereign bonds delivered average real returns of 6.85% annually
  • Only US equities (8.49%) and advanced country equity portfolios (8.25%) showed higher returns
  • Sovereign bonds significantly outperformed corporate bonds (-1.09%) and UK equities (5.47%)

Sovereign Default Haircuts Over Time

  • Average haircut in historical period (1815-1973) was 51%
  • Modern period (1995-2016) shows lower average haircuts of 37%
  • Median haircuts have remained below 50% throughout the sample period

Returns During Financial Crises

  • Sovereign bonds showed resilience during major financial crises
  • Returns recovered within 4 years after default events on average
  • High coupon payments helped stabilize returns during volatile periods

Contribution and Implications

  • First comprehensive analysis of sovereign bond returns over 200 years
  • Challenges assumption that sovereign debt is overly risky, showing sustained positive returns
  • Demonstrates that investors are compensated for sovereign default risk through high coupons

Data Sources

  • Historical returns comparison based on Table VII of the article
  • Haircut analysis derived from Table V comparing historical and modern periods
  • Crisis period returns constructed from data presented in Figure XI