Debt Seniority and Sovereign Debt Crises
44 Pages Posted: 1 Aug 2018
Date Written: May 2018
Is the seniority structure of sovereign debt neutral for a government's decision betweendefaulting and raising surpluses? In this paper, we address this question using a model ofdebt crises where a discretionary government endogenously chooses distortionary taxationand whether to apply an optimal haircut to bondholders. We show that when the size ofsenior tranches is small, a version of the Modigliani-Miller theorem holds: tranching justredistributes government revenues from junior to senior bondholders, while taxes andgovernment borrowing costs remain unchanged. However, as senior tranches becomesufficiently large, default costs on senior debt transpire into a stronger commitment to repaynot only the senior tranche, but also the junior one. We show that there is a lower thresholdfor senior bonds above which tranching can eliminate default on both junior and senior debt,and an upper threshold beyond which the government defaults also on senior debt.
Keywords: Debt crises; Sovereign default; Seniority; Eurobonds; Multiple equilibria; Self-fulfilling expectations, Debt crises, Sovereign default, Seniority, Eurobonds, Multiple equilibria, Self-fulfilling expectations, International Lending and Debt Problems, Asset Pricing
JEL Classification: F34, G12, H63
Suggested Citation: Suggested Citation