Extracting default probabilities from sovereign bonds

Abstract

Sovereign risk analysis is central in debt markets. Considering different bonds and countries, there are numerous measures aiming to identify the way risk is perceived by market participants. In such environment, probabilities of default play a central role in investors’ decisions. This article contributes by providing a parametric arbitrage-free dynamic model to estimate defaultable term structures of sovereign bonds. The proposed model builds on Duffie and Singleton’s (1999) general reduced-form model by proposing a piecewise constant structure for the conditional probabilities of defaults. Once an average recovery rate value is fixed for the whole market, the proposed model estimates implied probabilities of defaults from bond prices, working as a parsimonious tool to quantify investor’s perception of credit risk. We apply this methodology to analyze the behavior of default probabilities within the Brazilian sovereign fixed income market at three different recent economic moments.