Abstract
I study the term structure of credit default swap spreads to understand how global and country-specific risk factors explain time variation in sovereign credit risk. The shape of the term structure conveys significant information about the relative importance of global and domestic risk. Global shocks determine spread changes when the slope is positive. Nonetheless, a negative slope indicates that domestic shocks are relatively more important. To draw these conclusions, I develop a recursive preference-based model with long-run risk for credit default swaps. The underlying default process, which modulates expectations about future default probabilities, depends both on global macroeconomic uncertainty and country-specific risk. Their dynamics and investor preferences jointly explain time variation in the term structure. I evaluate the model using a panel of 44 countries. County-specific fundamentals explain relatively more spread variation than global factors as countries become more distressed. The number of months the term structure is inverted proxies for the duration of distress. Overall, the results suggest that both sources of risk are important. They simply matter in different times.