Macroeconomic Determinants of the Term Structure of Sovereign Credit Default Swap (CDS) Spread: Insights from MIDAS Regression

Abstract

When investors seek to diversify their investment portfolios across countries to maximize returns, they also expose themselves to additional risks, including the risk of sovereign defaults, which is a growing concern for investors in many countries worldwide. To better understand the factors critical to sovereign defaults, this study aims to investigate the impact of both country-specific and global factors on the term structure of Sovereign Credit Default Swap (CDS) Spreads, which acts as gauges for the extent of risk and vulnerability to credit defaults. Moreover, quarterly and monthly data from ten Eurozone countries, spanning from 2007 to 2022, is used and the MIDAS regression approach is applied. The empirical findings indicate that country-specific and global variables significantly impact sovereign risk, as measured by the term structure of sovereign CDS Spreads. However, the effect varies among the countries, possibly due to differing economic fundamentals and trade relationships with other countries. Among the country-specific variables, Local stock market returns, Forex Rate, and Debt-to-GDP ratio emerge as the most influential indicators. At the same time, impact of Changes in Reserve and Terms of Trade is less. U.S. Stock Return holds more influence among the global factors than U.S. Variance Risk Premium and U.S. Long-Term Yield. The study's outcomes have implications for investors, policymakers, and regulators.