Catalonian Bonds, Anyone?
Joint post by Mitu Gulati and Mark Weidemaier.
Sovereign bonds issued under the government's own law are supposed to be riskier than bonds issued under foreign (typically, English or New York) law. The logic is simple: Local-law bonds can be restructured with the stroke of a legislator's pen; with foreign bonds, it's not so easy. One would expect that difference in risk to show up in bond yields, which should be higher for local-law bonds, especially in times of uncertainty. There's quite a bit of research to back up that intuition (e.g., Bradley et al. (2017), Nordvig (2015), Chamon et al. (2014), Clare & Schmidlin (2014), Choi et al. (2014)).
Catalonian bond yields have been rising, thanks to jitters over the secession vote. But Nicolas Schmidlin, a fund manager (who worked on this topic as a graduate student and wrote the paper linked above), noticed something odd about bond yields.
As overall yields rise, one would expect the yield differential to increase between bonds governed by local law and bonds governed by foreign (in this case, English) law, reflecting the judgment that foreign-law bonds are safer in times of uncertainty. But that's not what is happening. Here's a simple yield curve, courtesy of Nicolas, with English-law bonds in red and Spanish-law bonds in blue.
One interesting aspect of this puzzle is that the local law in question is Spanish law. If Catalonia were to secede, it is not entirely clear what would happen to the designation of governing law in these bonds. Conceivably, the bonds might be treated as subject to laws passed by a Catalonian legislature--somewhat akin to how bonds payable in a government's own currency can be repaid in a new currency if the government adopts one. But a more likely outcome, we think, is that the bonds will continue to be governed by Spanish law, subject to the authority of unhappy legislators in Madrid. In a sense, this would convert the bonds from "local" to foreign law (in the sense that Catalonia can presently influence the development of Spanish law but will lose much or all of that ability if it secedes).
In any event, the issues surrounding state secession are uncertain--both about when there is a right to secede and about how debts are allocated post-secession. (For instance, in addition to its own debt, would Catalonia remain responsible for a share of outstanding Spanish government debt? If so, how much?) There's a nice story and podcast about the general topic on the BBC, titled How Do You Start a Country?
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