Persistence of volatility of sovereign credit risk in presence of structural breaks

The credit risk of a sovereign borrower is priced using bond spreads (BS) and credit default swaps (CDS). In this study, we investigate how structural breaks affect persistence of volatility of sovereign credit risk of seven countries. Using Kappa-1 and Kappa-2 tests, we identify multiple structural breaks in variance of both CDS and BS. Using exponential generalized autoregressive conditional heteroskedasticity model with and without structural breaks, we find that BS are more persistent than CDS hence informed trading takes place in sovereign bond market. The structural breaks are not only jointly significant in influencing volatility of sovereign credit but they reduce persistence of volatility and associated half-life of BS and CDS. The results have important implications on cost of borrowing of sovereigns, efficiency of CDS and BS markets as well as pricing of both credit risk measures. © 2014 Macmillan Publishers Ltd.