Debt Dilution and Sovereign Default Risk

Abstract

In this study, we measure the effects of debt dilution on sovereign default risk and consider debt covenants that could mitigate these effects. First, we calibrate a baseline model of defaultable debt (in which debt can be diluted) with endogenous debt duration, using data from Spain. Secondly, we present a model in which sovereign bonds contain a covenant that eliminates debt dilution. We quantify the effects of dilution by comparing the simulations of the model with and without this covenant. We find that dilution accounts for 79 percent of the default risk in the baseline economy. Without dilution, the optimal duration of sovereign debt increases by almost two years. Consumption volatility also increases, but eliminating dilution still produces substantial welfare gains. Introducing debt covenants that could be easier to implement in practice has similar effects. A covenant that penalizes the government for bond prices below a threshold is more effective in reducing the default frequency. A covenant that penalizes the government for debt levels above a threshold is more effective in reducing consumption volatility. These covenants could be useful for enforcing fiscal rules.