Debt Seniority and Sovereign Debt Crises

IMF Working Papers, May 9, 2018

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Debt Seniority and Sovereign Debt Crises

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Bibliographic details

• Authors: Anil Ari, Giancarlo Corsetti, Luca Dedola
• Published: May 9, 2018
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781484353691.001

Research question and model

• Research question: Is the seniority structure of sovereign debt neutral for a government's decision between defaulting and raising surpluses?
• Model framework:
  • A model of debt crises with a discretionary government that endogenously chooses distortionary taxation and whether to apply an optimal haircut to bondholders.
  • Focus on the size of senior tranches and how seniority affects default incentives and repayment commitment.

Key findings

• When the size of senior tranches is small:
  • A version of the Modigliani-Miller theorem holds: tranching redistributes government revenues from junior to senior bondholders, while taxes and government borrowing costs remain unchanged.
• When senior tranches become sufficiently large:
  • Default costs on senior debt generate a stronger commitment to repay not only the senior tranche but also the junior tranche.
• Existence of thresholds related to senior tranche size:
  • There is a lower threshold for senior bonds above which tranching can eliminate default on both junior and senior debt.
  • There is an upper threshold beyond which the government defaults also on senior debt.

Policy implications and interpretation

• Seniority design matters for sovereign debt outcomes when senior tranches are large enough to affect default costs and repayment incentives.
• Tranching can be neutral (pure redistribution across bondholders) or can substantially alter default behavior depending on senior tranche size relative to the identified thresholds.
• Understanding the position of a sovereign’s senior tranche size relative to the lower and upper thresholds is critical for anticipating whether debt seniority will reduce, have no effect on, or exacerbate sovereign default risk.

Content in this bundle

• Debt Seniority and Sovereign Debt Crises, WP/18/104, May 2018
  • Debt Seniority and Sovereign Debt Crises, WP/18/104, May 2018 (Markdown version)
  • Debt Seniority and Sovereign Debt Crises, WP/18/104, May 2018 (PDF)