How should global investors assess country sovereign bond and equity risks? In his July 2019 paper entitled “Country Risk: Determinants, Measures and Implications – The 2019 Edition”, Aswath Damodaran examines country risk from multiple perspectives. He provides an overview of sources and measures of country risk, addressing both sovereign bond default risk and equity risk premiums. Based on a variety of sources and methods, he concludes that:
- Country risk derives from levels of: maturity/resilience of principal industries; political stability; regulatory/legal clarity and efficiency; and, diversification across industries. For example, see the chart below.
- Measures of country risk include:
- Ranking/rating services, with the World Bank integrating six risk indicators from different services (encompassing corruption, government effectiveness, political stability, regulatory quality, rule of law and accountability) to grade 215 countries.
- Sovereign bond default risk ratings from Moody’s, S&P and Fitch (which all perform reasonably well, on average).
- Market interest rates, with focus on sovereign bond yields relative to those of duration-matched U.S. Treasuries (far more volatile than ratings).
- Credit Default Swap (CDS) prices (spreads), which tend to lead sovereign ratings and but also involve counter-party and liquidity risks (see the chart below).
- Three ways to estimate country equity risk premiums are:
- Use of historical returns in each market (problematic in many markets because short samples drive standard errors that are large compared to the premiums).
- Start with an equity risk premium benchmark for a mature market (such as the U.S.) and estimate incremental risk premiums for other countries based on sovereign default spreads and/or market volatilities relative to the benchmark market.
- Estimate an implied equity risk premium from stock prices and expected cash flows.
The following chart, taken from the paper, summarizes sovereign bond CDS percentage spreads across the globe as available in July 2019. The buyer of a CDS on a specific bond periodically pays the spread to the seller of the CDS. In return, the seller agrees to make the buyer whole if the issuer of the bond fails to pay. CDSs are unavailable for much of Africa. Large swaths of Latin America and Southern Europe exhibit high default risk.
In summary, investors have variety of methods to assess investment risk by country from different perspectives, but each method has shortcomings.
Cautions regarding conclusions include:
- As noted, each risk assessment method has weaknesses.
- The author does not put the risk assessment methods to work by designing and testing asset portfolios diversified across countries.
See also “Best Equity Risk Premium” and “Expert Estimates of 2019 Country Equity Risk Premiums and Risk-free Rates”.
