The Behavior of Emerging Market Sovereigns' Credit Default Swap Premiums and Bond Yield Spreads

We test whether credit risk for Emerging Market Sovereigns is priced equally in the credit default swap (CDS) and bond markets. The parity relationship between CDS premiums and bond yield spreads, that was tested and largely cofirmed in the literature, is mostly rejected. Prices below par can result in positive basis, i.e. CDS premiums that are greater than bond yield spreads and vice versa. To adjust for the non-par price, we construct the bond yield spreads implied by the term structure of CDS premiums for various maturities. We are able to restore the parity relation and cofirm the equivalence of credit risk pricing in the CDS and bond markets for many countries that have bonds with non-par prices and time varying credit quality. We detect non-parity even after the adjustment mainly in countries in Latin America, where the bases are larger than the bid-ask spreads in the market. We also find that the repo rates of bonds decrease around episodes of credit quality deterioration, which helps the basis remain positive