# **1. Introduction**

The battle of Waterloo in 1815 can be seen as the birthday of modern sovereign debt markets - and of their recurring boom-bust cycles. The Napoleonic Wars and the defeat of France and Spain accelerated the independence of a dozen new republics in Latin America, which quickly sought financing in London. The first emerging market debt boom, which also included the first Greek international bond, among others, ended abruptly in the financial panic of 1825. Since then, many similar cycles of lending and default have followed, often involving the same countries, again and again.

Given the frequent defaults and limited enforcement of external sovereign debt, why are investors attracted to this asset class? We tackle this question by examining how creditors have fared in sovereign debt markets over the short and long run with a focus on financial returns.<sup>2</sup> Two components are necessary to calculate total bond returns. The first of these is the price series. We collected monthly price quotations of 1,552 foreign-currency bonds issued and traded in London and New York over the past 200 years, with a total of 266,134 observations covering up to 91 countries, in an unbalanced sample.<sup>3</sup> Because of the recurring credit events of many of the sovereigns, prices and bond characteristics are necessary but not sufficient to calculate returns. The second required component is to quantify the investor losses due to sovereign default and debt restructurings (“haircuts”), for which we have compiled an extensive database covering missed payments, debt renegotiation terms, and face value write-downs in more than 300 debt crisis episodes since 1815.<sup>4</sup> We find that the ex-post returns on foreign-currency sovereign bonds compensate investors for the risks they face. Notwithstanding the defaults, wars, and global crises over the past two centuries, the average real yearly ex-post return on a global portfolio of external sovereign bonds was 6.9%. Thus, an investor entering this market with a one-year horizon can expect to receive on average a real ex-post return of almost 7% – about 4% higher than that of the “risk-free” benchmark of UK or US government bonds.<sup>5</sup> Excess returns are driven by the high coupons offered in this market. Not surprisingly, returns tend to be

> 2 External debt is defined here by currency rather than jurisdiction of issuance or residency of ownership. We focus on British pound and US dollar debt instruments and place of issue and trading (only those traded in London and/or New York). Hence, sample selection for our pricing data is not dictated by any priors other than location. Specifically, we start with emerging markets today and then move backward, adding sovereigns that have tapped London and New York markets in the past, including many of today’s advanced countries such as Australia, Canada, Germany, Greece, Italy, Japan, Portugal, and Spain.

> 3 London and New York were the two dominant trading centers in the 200-year sample (Michie 1987). Our country sample starts with about a dozen countries in the early19<sup>th</sup> century and grows over time, with gaps for individual countries and eras (especially the gap of the “syndicated loan era” of the 1970s and 1980s).

> 4 We use the term “haircut” to describe the size of creditor losses suffered in a sovereign default and debt restructuring. This wording is in line with the international macro and sovereign debt literature (e.g., Sturzenegger and Zettelmeyer 2008; Aguiar and Amador 2014). In finance, the term “haircut” is sometimes used differently, typically referring to a “repo haircut,” that is, the discount on the face value of an asset when valuing it as collateral in a repo transaction (Gorton and Metrick 2012).

> 5 These results, on the whole, show a higher rate of return for this asset class than a number of the earlier studies, which are mostly based on a different methodology and a more limited sample of sovereign bonds. See Section 2.

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