Controlling for bond and issuer characteristics, bond spreads are expected to be equal across different legal jurisdictions, and differences are expected to disappear through arbitrage. However, an analysis of 490 U.S. dollar–denominated bonds issued by 53 emerging market sovereigns during 1990–۲۰۱۵ reveals that after the financial crisis of 2008, launch spreads of sovereign bonds issued under U.K. law have been higher than those issued under U.S. law, by 130 basis points for BB+ bonds and 175 basis points for B− bonds. This effect was not significant for investment grade bonds. On average, bonds issued under U.K. law had weaker ratings and shorter tenors post-crisis. The post-crisis impact of governing law on sovereign bond spreads is not explained by collective action clauses, or first-time bond issuances. Instead, the difference seems to be related to the perception that U.S. law offers stronger investor protection, and that the investor base for bonds issued under U.S. law is larger than that for bonds issued under U.K. law. The difference in spreads persists in the secondary market even after 180 days, perhaps because of the lack of liquidity, as investors tend to buy and hold these more attractive bonds on a longer-term basis.

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. The use of governing law of an external jurisdiction other than that of the sovereign issuing debt (very often the U.S. or the U.K.) is a widespread practice especially among emerging market sovereign issuers. This is an attempt to mitigate risks associated with sovereign debt default by negating the possible influence a sovereign may have on its national courts. Yet the role of governing law as a distinguishing feature of a bond has received very little attention in the literature. The main research questions examined in this paper are: 1. 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? 2. What factors could explain such differences, if any? 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. An analysis of 490 sovereign U.S. dollar bonds issued by 53 emerging market sovereigns during 1990–۲۰۱۵ reveals that since the global financial crisis in 2008, the governing law seems to affect bond spreads for sub-investment grade bonds. During 2008–۲۰۱۵, 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. 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.