Extracting Default Probabilities from

Sovereign Bonds*
Bernardo Meres**
Caio Almeida***

Abstract
Sovereign risk analysis is central in debt markets. Considering different bonds and coun-
tries, there are numerous measures aiming to identify the way risk is perceived by mar-
ket participants. In such environment, probabilities of default play a central role in
investors’ decisions. This article contributes by providing a parametric arbitrage-free dy-
namic model to estimate defaultable term structures of sovereign bonds. The proposed
model builds on Duffie and Singleton’s (1999) general reduced-form model by proposing
a piecewise constant structure for the conditional probabilities of defaults. Once an av-
erage recovery rate value is fixed for the whole market, the proposed model estimates
implied probabilities of defaults from bond prices, working as a parsimonious tool to
quantify investor’s perception of credit risk. We apply this methodology to analyze the
behavior of default probabilities within the Brazilian sovereign fixed income market at
three different recent economic moments.
Keywords: Credit Risk, Term Structure of Interest Rates, Recovery Values, Jump Pro-
cesses.
JEL Codes: C5, C51.

* Submitted in June 2006. Revised in May 2008. We thank comments and suggestions from

seminar participants at the Sixth Brazilian Meeting of Finance, and we especially thank the
referee for important comments that led to an improvement of an earlier version of the paper.
The second author acknowledges support from CNPq-Brazil.
** Gávea Investimentos. E-mail: bcmeres@gaveainvest.com.br
*** Escola de Pós-Graduação em Economia, Fundação Getulio Vargas (EPGE/FGV).

E-mail: calmeida@fgv.br

Brazilian Review of Econometrics

v. 28, no 1, pp. 77–94 May 2008
 Bernardo Meres and Caio Almeida

1. Introduction
Implicit in any defaultable bond price is a premium related to the possibility
that the issuer of the bond might not fulfill its payment obligations. For this reason,
fixed income prices of risky bonds contain valuable information on the way risk
is perceived by market participants. In this work, we propose and implement a
simple dynamic term structure model, compatible with absence of arbitrages in
the market, which helps with the extraction of probabilities of defaults for coupon-
bearing bonds in emerging markets.
Credit risk modeling has been attracting the attention of researchers for at
least a couple of decades. Merton (1974) proposed a jump-diffusion model to
capture credit risk; Litterman and Iben (1991) studied a discrete-time model for
defaultable bonds with zero recovery and obtained that risky interest rates could
be represented by an adjusted short-term rate. Jarrow and Turnbull (1995) intro-
duced discrete-time Markov chains to model rating migrations in corporate bond
markets. Duffie and Singleton (1999) presented general results on reduced-form
term structure models. Collin Dufresne et al. (2004) proposed general formulas
for the pricing of defaultable claims.
Our model is a particular yet effective version of Duffie and Singleton’s (1999)
proposal. It builds on the discrete-time motivational model presented in the first
part of their paper, where conditional probabilities of defaults are fixed as constant
values. In contrast, we write the conditional probabilities of defaults as piecewise
constant functions. The duration in time for each constant part is motivated by
aiming at having a model with default factors capturing default probabilities whose
perceptions of risk are related to different horizons. Despite being motivated by
a discrete-time model, it is actually a continuous-time arbitrage-free model with
a simple functional form for the conditional probabilities of default.1 The most
interesting features of the proposed model are its parsimonious structure, its sim-
plicity in implementation, and its ability to easily interpret market perception of
defaultable bond risks by simple quantities, such as annualized conditional prob-
abilities of defaults and recovery rates for face values of bonds. These measures
are quite intuitive and well established in use by market participants. In addition,
it can be effectively applied to price new issues of bonds, as we shall observe in
subsection 3.3.
A number of credit risk crises have occurred during recent times. In 1997, the
Asian market suffered severe losses, and in August of 1998, the Russian market
collapsed. After Russia defaulted its ruble-denominated debt obligations, there
has been a thoughtful reevaluation of the concept of credit risk in global financial
markets.2 The number of complex credit derivative products, like collateralized
1 Note that the model is applied to a cross-section of data, and in this sense it works like a

static model. However, we could also have applied a dynamic version of the model to a time-series
dataset of defaultable bonds data.
2 At this point, we could also cite Brazil’s 1999 currency devaluation crisis, Argentina’s 2000-

78 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

debt obligations (CDOs) and credit default swaps (CDSs), traded in international
markets tremendously increased. People were much more concerned with the un-
derstanding and pricing of credit risk. From the empirical viewpoint, all these
crises motivated research where the main focus was to extract implied proba-
bilities of default and recovery rates from market data to give more support to
trading desks on the design and evaluation of credit derivative products. For in-
stance, Merrick (2001) introduced a joint implied parameter approach to extract
the expected recovery rates and default probability term structure from Russian
bonds. Andritzky (2002) adapted Jarrow and Turnbull’s model (1995) to esti-
mate default probabilities and recovery ratios from Argentinean bonds.3 Berardi
et al. (2004) adopted a recursive logit type model to predict default probabilities
of Global bonds4 in different emerging markets and make use of these predictions
to propose trading strategies for defaultable bond portfolios. Pan and Singleton
(2007) applied different term structure models to extract default probabilities and
recovery values from term structures of sovereign CDS spreads.
In our empirical application, we study the behavior of investor’s risk percep-
tion within an important fixed income emerging market: the Brazilian global
bonds market. By using the common market practice of fixing a predetermined
consensual value for the recovery rate, we extract implied probabilities of default
during three periods under clearly distinct economic situations: the international
crisis around September 11, 2001, the Brazilian local crisis during the presidential
elections in 2002, and an example of an economically stable period at the end of
2004.
As a second part of the application, we test the model’s ability to price an out-
of-sample bond. The ability of a model to price an out-of-sample bond is closely
related to its ability to price newly issued bonds. As it is usual to have countries
issuing new bonds, especially when their credit receives better classifications, it is
relevant to perform this out-of-sample test. Considering the 2004 dataset adopted
in the first part of the empirical application, we here estimate the model by ex-
cluding the 2030 global bond from the estimation dataset. This bond presents the
higher spread over treasury among all Brazilian global bonds on this date, and
for this reason, it represents a challenge if priced out-of-sample by the model. We
show that the model correctly prices the global 2030 out-of-sample bond, offering
a statistical error of less than five basis points on the spread over treasury of this
bond, an error of the order of one tenth of the statistical error obtained under a
linear interpolation scheme.

2001 currency devaluation crisis, and the September 11, 2001 attack on the twin towers in New
York.
3 The hazard rate, defining instantaneous probabilities of default, was modeled by using a

Gumbel probability distribution.

4 A Global bond is a sovereign coupon-bearing bond issued in a foreign currency (usually in

dollars), in a foreign market.

Brazilian Review of Econometrics 28(1) May 2008 79

 Bernardo Meres and Caio Almeida

The rest of the paper is organized as follows. Section 2 presents the theoretical
model and the estimation methodology. Section 3 presents the model estimation
results and discusses the empirical application outlined above. Section 4 summa-
rizes the paper and presents some concluding remarks.

2. The Model
Consider a defaultable contingent claim that promises to pay Xt+τ at its ma-
turity date t + τ . Assume the existence of a risk-neutral measure Q under which
discounted prices of defaultable bonds are martingales. This insures the absence
of approximate arbitrages in the market (see Duffie (2001)).
Now, let rs represent the default-free short-term rate,5 hs denotes the prob-
ability of a default happening between s and s + 1, conditional on information
available up to time s, in the event of no default by s, and φs denotes the recovery
values in dollars, in the event of a default. It is immediate to verify that the fair
price of the defaultable contingent claim at time t, as a function of its price at
time t + 1, should be written as a sum of two terms: one paying the recovery value
φt+1 in the event of default happening between times t and t + 1; and the other
one paying the discounted fair price at time t + 1, in the event of no default:

Vt = ht e−rt EtQ (φt+1 ) + (1 − ht )e−rt EtQ (Vt+1 ) (1)

Duffie and Singleton (1999) applied a recursive argument to show that the price
at time t is the following function of the payoff Xt+τ :

 
τ −1 j
X Pj Y
Vt = EtQ  ht+j e− k=0 rt+k
φt+j+1 (1 − ht+l−1 )
j=0 l=0
τ
!
Pτ −1 Y
+ EtQ e − k=0 rt+k
Xt+τ (1 − ht+j−1 ) (2)
l=0

They obtained the following important result: If, under the event of a default
at time s + 1, the recovery value is a fraction 1 − Ls of the market value of the
bond at time s + 1 (not a function of its face value), then equation (2) simplifies
to:

Q −rt Q
Vt = ht e−r
 (1 − Lt )Et (Vt+1) + (1 − ht )e Et (Vt+1 )
t
Pτ −1
= EtQ e− k=0 Rt+k
Xt+τ (3)

5 Represented in this paper by the short-term rate implied by U.S. swaps.

80 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

with

e−Rt = (1 − ht )e−rt + ht e−rt (1 − Lt ) (4)

Duffie and Singleton (1999) noted in addition that for annualized rates and
time periods of small length, equation (4) can be further simplified to yield that
the defaultable short-term rate is approximately equal to the default-free short-
term rate plus the product of the loss rate Lt and the conditional probability of
default ht at time t: Rt = rt + ht Lt . They show that this approximation for
the defaultable short-term rate is exact in continuous time (Theorem 1 on page
697). No restriction is imposed on the hazard rate process h in order to render
the theorem valid, and we use this fact to propose our model.

2.1 The piecewise constant model

In this paper, we propose to have a constant loss rate L and conditional prob-
abilities of default expressed by a piecewise constant function:
N
X
ht = Hj I(tj−1 < t < tj ) (5)
j=1

where I represents the indicator function which assumes one or zero depending
on t being within the indicated interval or not, and H1 , H2 , ..., HN are constants.
Figure 1 depicts an example of the conditional probabilities of default function
defined by equation (5).

Figure 1
An example of conditional probabilities of default through time

Brazilian Review of Econometrics 28(1) May 2008 81

 Bernardo Meres and Caio Almeida

The piecewise constant function is a particular hazard rate process and by

Theorem 1 in Duffie and Singleton (1999) our version of their model is arbitrage-
free if we consider that the defaultable short-term rate is given by Rt = rt + ht Lt
at time t. The implications of this particular choice of conditional probabilities
for the shape of the yield curve can be obtained by analyzing the price of a bond
with time to maturity T :

Pt+T  Pt+T 
P (t, t + T ) = e−L k=t+1 hk
EtQ e k=t+1 rk
PM
= e−L( k=1 Hk (tk −tk−1 )+HM +1 (T −tM ))
Pdef aultf ree (t, t + T ) (6)

where M is such that tM < T < tM +1 and Pdef aultf ree (t, t + T ) represents the
time t price of a default-free bond with time to maturity T .
Note that this model implies a parametric arbitrage-free model6 for the term
structure of interest rates:

M
!
L X
R(T ) = Rdef aultf ree (T ) + Hk (tk − tk−1 ) + HM +1 (T − tM ) (7)
T
k=1

The term structure is expressed as a risk-free curve added to a constant and

a hyperbolic function which changes its curvature according to the different levels
of conditional probabilities of default. An interesting point of this model is the
existence of a closed-form formula for the term structure of interest rates and its
simultaneous compatibility with absences of arbitrage in the market, a character-
istic which is not shared by most of the parametric term structure models.7 In
this paper we estimate cross-sectional versions of the model and therefore only deal
with the risk-neutral probability measure. On the other hand, if we were interested
in analyzing a dynamic version of the model by considering transition densities of
the bonds, a stochastic hazard rate would be more appropriate in order to produce
a stochastic spread curve. Moreover, the piecewise constant structure implies a
parametric arbitrage-free version of the flat-forward method, frequently adopted
by market participants to interpolate interest rate curves. The flat-forward method
assumes that forward rates between observed interest rate zero-coupon rates are
taken to be piecewise constant with no economic justification. In some sense, our
model brings economic justification to this widely adopted method.

6 Parametric term structure models are those which present a closed-form formula for the term

structure of interest rates. For instance, Nelson and Siegel (1987) represent the term structure
as a linear combination of exponential functions.
7 See Sharef and Filipovic (2004) for an exception: an example of a parametric term structure

model which is also arbitrage-free.

82 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

Figure 2 presents an example of an implied term structure of spreads over the

risk-free rate, for a fixed loss fraction L = 0.5, when we adopt respectively one, two
or three default factors, represented here by the conditional probabilities of default
H1 , H2 and H3 from equation (5). The top plot considers the spread structure
when only H1 describes all conditional probabilities of defaults. In this case, the
spread is constant and captures, as a particular case, the static spread method
widely adopted by market participants. When a medium-term default factor is
introduced (represented by the existence of H2 ), the medium-term spreads take
the form of a concave function as can be observed in the second plot of Figure 2.
Finally, when a third default factor, representing long-term defaults, is included,
long-term spreads are allowed to have a curvature distinct from medium-term
spreads, offering more flexibility to the shape of the spread curve. This is shown
in the third plot. The values adopted to generate this example were H1 = 0.08,
H2 = 0.1 and H3 = 0.12, t0 = 0; t1 = 5; t2 = 10; t3 = 20.

Figure 2
An example of implied term structure of spreads

Brazilian Review of Econometrics 28(1) May 2008 83

 Bernardo Meres and Caio Almeida

2.2 Estimation process

We assume that the prices Pj , j = 1, ..., m and cash flows Cjk , j = 1, ..., m; k =
1, .., γj of m defaultable bonds are observed, with error. Cash flow k of bond j is
paid at Tjk . Given a value for the loss rate L,8 we apply a nonlinear least squares to
minimize pricing errors so as to obtain the values of the constants Hi , i = 1, ..., M
that determine the implied probabilities of default:
γj
X
Pj = Cjk e−Tjk R(Tjk ) + j (8)
k=1

where R(.) is parameterized by equation (7).

An important issue on the definition and estimation of the model is related to
the number of factors M that will drive the conditional probabilities of default.
Since the residuals from the estimation process come from a nonlinear pricing
equation (8), usual asymptotic t significance tests would not be a good choice.
Instead, a formal statistical significance test could be performed with the use of
a nonparametric bootstrap method (Davison and Hinkley, 1997), or alternatively
with the use of information criteria methods (see, for instance Sakamoto et al.
(1986)). However, in the empirical section, we choose to fix the number of factors
at three, consistently with seminal results in Litterman and Scheinkman (1991),
later confirmed by a large number of papers9 indicating that a large number of
term structures around the world have their movements primarily driven by three
factors. In particular, Almeida et al. (2003) applied principal components to a
time series of data in the Brazilian global market (the market analyzed in this
paper), finding that three movements are important to drive this term structure.
Another important point for discussion is the assumption of a constant prede-
termined loss rate, which is usual in the literature of reduced-form models. Duffie
and Singleton (1999) clearly show that based on only bond data, the processes Lt
and ht are not separately econometrically identifiable.10 In this paper, we adopt
a common market strategy that is to fix the loss rate at a certain value that is
the market expected loss rate within each sovereign bond market (see Beinstein
and Scott (2006) or Doctor and Goulden (2008)). This strategy has also been
adopted in a number of recent academic papers including Houweling and Vorst
(2005), Pan and Singleton (2007). What is important to bear in mind is that
compared to implied probabilities of default, the loss rate is a secondary variable
since usually market participants consider only a few possible values as possible
8 Recovery rate is directly related to loss rate via φ = (1 − L).
9 See, for instance Almeida et al. (2003) for an analysis of the Brazilian global market, Dai
and Singleton (2000) for U.S. swaps, and Tang and Xia (2007), for Japan, U.S. and U.K, among
many others.
10 If data on nonlinear instruments, such as credit default options, is available, then these two

processes can be separately identified. More recently, Pan and Singleton (2007) showed a way to
separately identify these two processes from credit default swap data.

84 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

for a market expectation consensus like 0.15, 0.2 0.25, 0.4, 0.5 or 0.75. So, even if
a certain investor does not believe that the market expected loss rate is correct, or
in other words, that bond prices are correct, he/she can back out implied proba-
bilities of default with his/her model using the market expected loss rate and then
recalculate bond prices with his/her own expected loss rates.

3. Empirical Results
3.1 Data
The data consist of prices and cash flows of Brazilian global bonds on three
different days with very distinct market behavior: 10/08/2001, the day of worst
results for global bonds in 2001, after the September 11 external crisis; 09/27/2002,
the day of smallest global bond prices considering their whole history, reflecting a
strong internal Brazilian crisis; and 11/19/2004, a day in the middle of a period
reflecting economic stability. Table 1 presents global bonds characteristics, such
as date of settlement, date of maturity, and coupon values.11 Bootstrapped12 U.S.
swap rates represent our risk-free term structure of interest rates. These risk-free
rates are obtained from a set of Libor short-term rates (3m, 6m, and 1 year) and
U.S. swaps for maturities 2, 3, 5, 7, 10, 20, and 30 years. The data were collected
at a Bloomberg terminal.13

Table 1
Cash flow characteristics of global bonds

Instrument Data of settlement Date of maturity Coupon

Brasil 2004 04/30/1999 04/15/2004 11.625%
Brasil 2005 05/17/2001 07/15/2005 9.625%
Brasil 2007 07/26/2001 07/26/2007 11.25%
Brasil 2008 03/12/2002 03/12/2008 11.50%
Brasil 2009 10/25/1999 10/15/2009 14.50%
Brasil 2010 04/16/2002 04/15/2010 12.00%
Brasil 2011 08/07/2003 08/07/2011 10.00%
Brasil 2012 01/11/2002 01/11/2012 11.00%
Brasil 2013 06/17/2003 06/17/2013 10.25%
Brasil 2014 07/14/2004 07/14/2014 10.50%
Brasil 2019 10/14/2004 10/07/2019 8.88%
Brasil 2020 01/26/2000 01/15/2020 12.75%
Brasil 2024 03/22/2001 04/15/2024 8.88%
Brasil 2027 06/09/1997 05/15/2027 10.13%
Brasil 2030 03/06/2000 03/06/2030 12.25%
Brasil 2034 01/20/2004 01/20/2034 8.25%
Brasil 2040 08/17/2000 08/17/2040 11.00%

11 All
globals pay semi-annual coupons.
12 Bootstrapping is a recursive procedure, which extracts zero-coupon yields from a set of
coupon-paying instruments, that might be bonds or swaps. See Brigo and Mercurio (2001) for a
detailed explanation.
13 For more information on this data feeder, see www.bloomberg.com.

Brazilian Review of Econometrics 28(1) May 2008 85

 Bernardo Meres and Caio Almeida

3.2 Comparison of default probabilities in 2001, 2002 and 2004

Tables 2, 3, and 4 present observed and model-implied prices and spreads over
treasury14 for globals on the three previous dates selected. Note how different the
observed prices (and consequently the spreads) were during these three moments.
For instance, the average price of the bonds presented in Table 2 was $77.07.
Compare this value to the average prices of this same subset of bonds extracted
from Tables 3, and 4, which were, respectively, $46.41 and $120.24, to identify
that, on average, these bonds had a loss of 40.2% of their value when investor’s
risk perception deteriorated from 10/08/2001 to 09/27/2002, and after that they
had a 159% increase in value when the risk perception turned from very pessimistic
in 2002 into considerably optimistic in 2004.
Table 2
Observed and estimated prices and spreads on 10/08/2001

Instrument Estim. price Observ. price Estim. spread Observ. spread

Brazil 2004 93.74 94.10 1129 1110
Brazil 2005 84.32 83.40 1122 1159
Brazil 2007 83.27 83.90 1127 1108
Brazil 2008 74.71 77.35 1112 1033
Brazil 2009 92.59 90.50 1147 1198
Brazil 2020 72.15 73.00 1288 1265
Brazil 2027 59.44 60.00 1205 1188
Brazil 2030 69.51 70.35 1256 1234
Brazil 2040 63.55 61.00 1218 1294

Table 3
Observed and estimated prices and spreads on 09/27/2002

Instrument Estim. price Observ. price Estim. spread Observ. spread

Brazil 2007 51.13 51.00 2854 2863
Brazil 2008 49.92 50.00 2794 2789
Brazil 2009 53.33 54.00 2785 2746
Brazil 2010 47.51 46.50 2636 2698
Brazil 2012 43.92 44.25 2469 2450
Brazil 2020 46.20 46.25 2416 2413
Brazil 2024 37.74 38.50 1989 1941
Brazil 2027 40.45 39.75 2129 2175
Brazil 2030 45.18 45.50 2340 2320
Brazil 2040 42.38 42.00 2216 2240

14 The spread over treasury of a bond is defined as the difference between its internal rate of

return and the internal rate of return of a U.S. bond with the same duration of the risky bond.
For a definition of duration, see Fabozzi (2001).

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 Extracting Default Probabilities from Sovereign Bonds

Table 4
Observed and estimated prices and spreads on 11/19/2004

Instrument Estim. price Observ. price Estim. spread Observ. spread

Brazil 2007 113.89 114.00 212 208
Brazil 2008 116.23 116.15 240 243
Brazil 2009 129.77 129.50 329 335
Brazil 2010 120.28 120.60 340 333
Brazil 2011 111.32 110.25 364 383
Brazil 2012 116.37 116.25 374 376
Brazil 2013 112.07 113.25 389 371
Brazil 2014 113.27 113.75 399 393
Brazil 2019 100.29 100.50 402 399
Brazil 2020 128.64 128.25 443 447
Brazil 2024 98.88 99.00 404 403
Brazil 2027 108.54 109.00 426 421
Brazil 2030 125.71 126.00 458 455
Brazil 2034 92.77 92.40 390 394
Brazil 2040 115.50 114.70 446 453

The model was estimated using the methodology described in Section 2. We

decided to adopt a total of three constants to describe the conditional default
probabilities defined by Equation (5). These three constants would stand for
short-term, medium-term and long-term expected default rates, similarly to the
interpretation of Nelson and Siegel’s (1987) forward rate functions. More factors
could be easily introduced, but for each introduced factor we would be specializing
the ability of the default factors to smaller intervals of time, and the model would
become less parsimonious. Based on the last observation, it is interesting to note
that a second important decision concerns the interval sizes attached to each factor.
For a formal econometric selection, we would incur serious computational time
due to the combinatorial nature of the problem.15 Despite that, we decided to
arbitrarily fix the short-term factor to be active from time to maturity zero up to
the maturity of the shortest maturity global bond.16 The medium-term factor is
active for five years, beginning at the point of inactivity of the short-term factor.17
Finally, the long-term factor is active from the point of inactivity of the medium-
term factor up to the maturity of the longest maturity global bond, the 2040
global. For instance, on 09/27/2002, there were 5 years up to the maturity of
the 2007 global. Then, the short-term factor was active from 0 to 5 years, the
medium-term factor was active from 5 to 10 years, and the long-term factor from
10 to 38 years.

15 For instance, we would have 40 years of maturity to split between three factors. The total
42!
number of possible ways to do that, considering only whole numbers on the split, is 40!2! = 861.
16 The 2004 global when the 2001 dataset is adopted, and the 2007 global when the remaining

datasets are adopted.

17 With an exception in 2004, where it is active for 7 years, to compensate for low probabilities

of default in the medium-term range.

Brazilian Review of Econometrics 28(1) May 2008 87

 Bernardo Meres and Caio Almeida

Note in Tables 2, 3, and 4 how observed and estimated prices were close. The
root mean square errors18 (RMSE) were respectively $1.52, $0.54 and $0.51, which
are considerably low values when compared to average prices. Table 5 presents
the values of predetermined fixed recovery rates, conditional default probabilities,
accumulated probabilities of default, and forward default probabilities19 obtained
for the three datasets of global bond prices. Figure 3 depicts a plot of the con-
ditional probabilities of default functions extracted from bond prices. Note how
probabilities present clearly different orders. For instance, short-term conditional
probabilities of default in 2002 were higher than all conditional default probabili-
ties extracted from 2001 and 2004 global bond prices. The long-term probabilities,
which reflect market fundamental expectations regarding the Brazilian financial
credibility, are in 2002, around eight times the value obtained in 2004 (66.88% in
2002 against 8.79% in 2004). In 2002, close to the moment when President Lula
assumed his position, the market had a catastrophic view for the future of the
Brazilian financial market, practically expecting a default on a long-term basis,
with certainty. This is directly quantified by the model that for a fixed recovery
rate of 20% obtained a long-term conditional probability of default of 66.88%,
with an accumulated probability of default of 97.25% for the period between 2002
and 2012. That is, the market expected in 2002, a 97.25% chance that default
would occur in the next 10 years. This value dropped to 49.13% in 2004 as can be
observed in Table 5. Figure 4 shows accumulated probabilities of defaults. The
higher the slope, the faster the market would be expecting a default. For instance,
in 2002, market participants expected a default with probability very close to one,
in the next 15 years, in 2001, in the next 22 years, and in 2004, after the next 50
years. Other comparisons could be performed if we wanted to explore the term
structure of default probabilities. For instance, we could use the forward proba-
bilities of default, which are the conditional accumulated probabilities of default
between two intervals of time, to compare one fixed interval of time (say the pe-
riod between 2007 and 2010) among the three models estimated based on the three
different Brazilian economic moments (2001, 2002 and 2004).

 2
18 Defined 1 Pm
as m j=1 Pj − P̂j .
19 Letting p denote survival probability up to time t, fixed s > t, the forward default proba-
t
bility for the period between t and s is defined by 1 − pps .
t

88 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

Figure 3
Conditional probabilities of default at different economic moments

Figure 4
Accumulated probability of defaults at different economic moments

Brazilian Review of Econometrics 28(1) May 2008 89

 Bernardo Meres and Caio Almeida

Table 5
Model-implied measures of default

Date Default factor Average Cond. Accum. prob. Forw.

recovery default default default
rate prob. prob.
10/08/2001 short-term (0 to 3 years) 15.0% 12.63% 31.53% (up to 3 y) 31.53%
10/08/2001 medium-term (3 to 8 years) 15.0% 13.04% 64.43% (up to 8 y) 47.99%
10/08/2001 long-term (8 to 39 years) 15.0% 30.75% 100% (up to 39 y) 99.99%
09/27/2002 short-term (0 to 5 years) 20.0% 37.15% 83.84% (up to 5 y) 83.84%
09/27/2002 medium-term (5 to 10 years) 20.0% 34.00% 96.27% (up to 10 y) 81.22%
09/27/2002 long-term (10 to 38 years) 20.0% 66.01% 99.8% (up to 38 y) 99%
11/19/2004 short-term (0 to 3 years) 40.0% 3.40% 9.68% (up to 3 y) 9.68%
11/19/2004 medium-term (3 to 10 years) 40.0% 8.27% 49.50% (up to 10 y) 44.04%
11/19/2004 long-term (10 to 36 years) 40.0% 8.85% 95.53% (up to 36 y) 90.48%
Average recovery values were taken from the Bloomberg website as a consensus from the market
around each of the three dates analyzed. Forward default probabilities are conditional for periods
in between factors. For instance, in the second line last column, 47.99% indicates a conditional
probability of default between 3 and 8 years.

One point which is worth mentioning is that the 2040 global bond presents an
embedded call option within its cash flow. During the three dates analyzed here
the option was deep out-of-the-money and we could price the bond without taking
the option into account. However, if an analysis were to be performed with more
recent data, the option would be in-the-money and should be priced. In this case,
we would have to adopt an option pricing model such as Black et al. (1990), or
Hull and White (1990), among others.

3.3 Pricing an out-of-sample bond: The 2030 global

Once a reduced-form model is used to extract the term structure of interest
rates from sovereign bonds, it is a simple task to provide model-implied fair prices
for all those bonds. However, one may argue that even when the model has a
good in-sample fit, it might be only for statistical reasons (we are minimizing the
RMSE), and not because the model explains important aspects of this assets valu-
ation. In order to test the validity of the model, from an asset pricing perspective,
we will perform a simple out-of-sample exercise: we will estimate the Brazilian
term structure of sovereign bonds, excluding one bond, and then we will compare
the model-implied fair price to the observed price of this bond. Considering prac-
tical purposes, this is useful whenever a new bond is issued in the market and
needs to be priced.
Figure 5 presents a plot frequently adopted by financial institutions: a spread
× duration20 plot for the Brazilian global bonds on 11/19/2004. Market values
are represented by stars, model-implied values are represented by dots, and the
whole line represents a quadratic polynomial fit of the observed market data usu-
ally adopted by practitioners to make decisions about investment opportunities in
20 Roughly speaking, it represents the cash flow of a coupon-bearing bond by a simple zero-

coupon cash flow with time to maturity equal to a properly weighted average of all the cash
flows of the original bond, and with yield to maturity equal to the internal rate of return of the
original bond.

90 Brazilian Review of Econometrics 28(1) May 2008

 Extracting Default Probabilities from Sovereign Bonds

emerging markets. It is important to say that this picture was obtained after an
estimation of the model including all global bonds presented in Table 4. At this
point, we have an important choice to make: which bond will be left out of the
sample estimation dataset? Observing Figure 5 we have chosen the 2030 global
because it presents the highest spread among all Brazilian global bonds. By tak-
ing the bond with the highest spread, we want to show that our model performs
clearly better than an interpolation scheme. On 11/19/2004, the market closing
price for the 2030 global bond was $ 126.00, which implied a value for the spread
over treasury equal to 455.46 basis points (bps).21 While its spread market value
corresponded to 455.46 bps, the model estimated a spread of 459.98 bps22 for this
bond when it was included in the estimation sample. After re-estimating the model
without considering the 2030 global, the out-of-sample implied spread was 463.4
bps, an error of less than 8 bps. If we were applying a linear interpolation scheme
of the spreads, the error would be much higher, as can be observed by noting the
line connecting the spreads of 2019 global and 2027 global, the two globals with
duration values closest to the duration of the 2030 global. This line would imply a
spread of 414.5 bps for the 2030 global, an error of 41 bps, five times greater than
the model-implied error.

Figure 5
Spread over treasury × duration plot for Brazilian global bonds on 11/19/2004

21 Pointed out by a star in Figure 5 under the label “GL30”.

22 The model in fact estimated a fair price of $ 125.5, which is readily converted to the spread
of 459.98 bps using the formulas from Fabozzi (2001).

Brazilian Review of Econometrics 28(1) May 2008 91

 Bernardo Meres and Caio Almeida

4. Conclusion
We propose and implement a dynamic term structure model useful to price
defaultable bonds. The goal was to extract default probabilities from Brazilian
global bond data and analyze the risk perception of investors during different
economic periods. The model builds on Duffie and Singleton’s (1999) work, writing
the conditional probabilities of default driving the dynamics of bond prices as a
piecewise constant function. In the empirical implementation, the dynamic factors
driving defaults are specialized to three: a short-term, a medium-term and a long-
term factor, resembling Nelson and Siegel’s (1987) interest rate factors. It is shown
that the model is able to offer intuitive results relating levels of default probabilities
to observed bond prices, as suggested by a joint analysis of Tables 2, 3, 4, and
Figure 4. An empirical out-of-sample pricing exercise of the 2030 global bond
provides a consistent result, with an error of less than 8 bps, indicating that this
model might be useful to price newly issued bonds. In summary, the model is
consistent with no-arbitrage, parsimonious, and presents easy interpretation of its
results. One possible extension for a future work would be to consider more general
functions to represent the conditional probabilities of default, such as linear, or
quadratic functions of maturity, or even stochastic functions like the one considered
by Duffie et al. (2003).

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