# 1. Introduction

This paper explores whether the governing law has any lasting impact on sovereign bond spreads. Foreign currency sovereign bond issuances comprise a significant and vital part of total emerging market (EM) bond issuance. Sovereign bonds are important not only for government finances, but also for providing a benchmark for sub-sovereign borrowings. Conventionally, controlling for bond and issuer characteristics, spreads are expected to be equal across different legal jurisdictions. Differences in spreads, if any, are expected to disappear over time through arbitrage. The main research questions examined in this paper are:

1. What are the stylized facts about sovereign US dollar bonds issued by emerging markets before and after the financial crisis?

2. Are there systematic differences between the spreads of dollar-denominated emerging market sovereign bonds issued under U.K. and U.S. law, after controlling for bond and issuer characteristics?

3. What factors could explain such differences, if any?

Contrary to expectations, an analysis of 435 sovereign U.S. dollar bonds issued by 53 emerging market sovereigns during 1990-2015 reveals that since the global financial crisis in 2008, the governing law seems to affect bond spreads for sub-investment grade bonds. During 2008-2015, the launch spread of sovereign bonds issued under U.K. law has been higher than those issued under U.S. law. While the difference in spreads was not significant for investment grade bonds, it ranged from 130 basis points for BB+ bonds to 175 basis points for B- bonds.<sup>2</sup> Collective action clauses (CACs) that reduce the possibility of minority investors holding out on a debt settlement with a borrower, which were featured originally in U.K. law but not in U.S. law, are a possible source of differences in bond spreads. But empirical evidence from the literature is inconclusive on this point. CACs are now common in bonds issued under both U.K. and U.S. governing law. Another possible source of spread difference is a first-time bond issuance by a new borrower.

After controlling for bond characteristics such as ratings, tenor, issue size and country growth, plausible explanations such as presence of CACs and first-time issuances do not adequately explain this difference. However, bonds with U.S. SEC registration attract lower spreads. Further, the difference in spreads arises due to lower spreads of U.S. law bonds in the post-crisis period. This may indicate that the increase in risk aversion following the crisis, the greater investor protection brought in by legislations, and consequent flight to the safety of SEC registered bonds increased the value of U.S. law bonds in the perception of investors.

The difference in spreads based on governing law observed may be related to the perception that U.S. law offers stronger investor protection and a higher degree of regulatory enforcement especially. For instance, Jackson (2007) states: “Compared to at least the United Kingdom and Germany, the intensity of securities enforcement actions in the United States appears to be strikingly higher. Not only are there more financial regulators in the United States, but they also carry bigger sticks than their foreign counterparts. While the laws on the books may be converging, the level of enforcement efforts seems to vary widely across national boundaries and even within regions such as Europe.” There has also been a change in the investor base for emerging market bonds. Post-crisis, the volume of assets managed by mutual funds has increased while hedge fund investment in emerging markets has stagnated (International Monetary Fund 2014). This may imply a greater move towards safer assets. Also the U.S. investor base is much larger. For instance, the volume of international portfolio investment

> 2 The spread difference is found to be broadly unchanged even after 180 days of trading in the secondary market. This adds to the list of observed post-crisis deviations from long-standing theoretical and empirical regularities such as the violation of covered interest rate parity in foreign exchange markets (Borio et al. 2016).

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