Sovereign loans by Multilateral Development Banks (MDBs) are non-traded assets. MDBs set spreads on such loans without differentiating between the ratings of the sovereign borrower in question1 and they do so in an administrative way influenced more by the MDB’s overhead costs than notions of return on risk.2 Hence, MDBs are rarely concerned with the market value of their assets.
The fair pricing of MDB sovereign loans does become an issue, however, when MDBs seek to transfer risk on these assets. Then counterparties which may include private sector investors will wish to understand how the loans should be valued.
This paper devises and applies an approach to pricing MDB loans. Starting from data on US-dollar denominated sovereign bonds, we infer fair market spreads conditional on rating. Adjusting these spreads for the Preferred Creditor Treatment (PCT) of MDB loans, we obtain spreads conditional on ratings and tenor for MDB sovereign loans.
Our earlier study entitled “Quantifying MDB Sovereign Loan PCT by Rating” (Risk Control (2023)) presented estimates of 1-year sovereign Probabilities of Default to without-PCT entities (e.g., private sector bondholders) and with-PCT lenders (e.g., MDBs). To infer multiperiod PDs, one may embed a PCT-inclusive vector of rating specific PDs in a rating agency transition matrix. Risk Control (2024) showed how this may be done while retaining the transition probabilities between non-default ratings evident in historical ratings data. This involves distinguishing between moderate-severity sovereign defaults (in which the sovereign defaults to non PCT institutions such as private sector bondholders) and extreme-severity defaults in which they default to PCT-enjoying institutions like MDBs as well.
In this study, we use the split of probability weight between the moderate and extreme-severity defaults found in the historical transition matrix to infer a split in risk adjusted probability weight between these two default states in the risk adjusted matrix and, thereby, to infer the appropriate magnitude of sovereign spreads for PCT inclusive claims.
Read the full paper here.
