The determinants of cross-border bond risk premia

Abstract

Although cross-border bond issuance by emerging market economies (EMEs) has surged and dominated financing since the financial crisis of 2008, the sources of variation in cross-border bond risk premia have been ignored. This study fills this gap in the literature by examining the dynamic impact of interest rate differentials, exchange rates, and the broad dollar index on cross-border bond risk premia by applying a time-varying parameter vector autoregression (TVP-VAR) model with stochastic volatility. Generally, the risk premia responses are time-varying, lagged, and heterogeneous, with a reduction as the lag time horizon expands and the most significant in major global events. The empirical findings highlight that the broad dollar index dominates in explaining the variation of cross-border bond risk premia rather than the other two potential factors; we call this the “cross-border bond risk premia puzzle.” Furthermore, we find that the broad dollar index positively impacts cross-border bond risk premia via two transmission channels: 1) exchange rate expectations, which are significantly negatively driven by the broad dollar index, and 2) risk sentiment, which is negatively reflected by the index itself; both effects are negative. Moreover, the effect of the broad dollar index on risk premia is more pronounced for high-yield bonds than for investment-grade bonds. High-yield bond risk premia are negatively driven by exchange rate expectations, while investment-grade bond risk premia are positively driven by the local currency spread. Finally, these findings provide fresh insights into the aforementioned relationships; thus, we outline the implications.