Sovereign risk mitigation mechanism in emerging markets

TL;DR

This paper proposes a novel sovereign risk mitigation mechanism for emerging markets using tranche-based sovereign bond portfolios, aiming to create safe assets and support financial market development.

Contribution

It introduces a feasible, non-mutualized pooling mechanism with tranche structuring to mitigate sovereign risk and promote financial market growth in emerging markets.

Findings

Senior bonds act as safe assets.

Junior bonds' risk depends on portfolio structure.

Mechanism supports financial development and aid tasks.

Abstract

This paper explores a mechanism for mitigating sovereign risk in emerging markets without risks mutualization. The mechanism involves pooling diversified portfolios of sovereign bonds and issuing them in tranches, with the senior tranche offering low-risk payoffs protected by the subordination of the junior tranches. We argue that this mechanism is feasible for emerging markets. The senior bonds issued by the securitization vehicle attain the properties of a safe asset. The risk level of the junior bonds depends on the structure of the underlying sovereign bonds portfolio. Nevertheless, the properties of the synthetic bonds are, arguably, acceptable for the practical application of the proposed mechanism in promoting the development of financial markets in emerging markets and for practical tasks such as intergovernmental aid or lending.