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Answer: Countries that have larger commitments to provide health care and pay pensions to their citizens will have higher default risk than equivalent countries that do not.
**B is correct.** As the size of a government's commitments to pay pensions and provide health care increases, the government has less free cash to service debt, which increases default risk. **A is incorrect.** During economic downturns, developing countries often see larger declines in GDP than their developed counterparts because developing economies tend to rely more heavily on commodities and get squeezed by lower prices and demand during global recessions. **C is incorrect.** Government debt-to-GDP ratio is not a complete measure of sovereign default risk. For example, Japan has a much higher government debt-to-GDP ratio than most countries but holds substantial assets, making its adjusted debt-to-GDP ratio more reasonable. **D is incorrect.** When a country defaults, the old debt is usually replaced by new debt or restructured (e.g., by lowering principal, lowering interest payments, or extending the debt life), so investors typically do not lose the entirety of their investment.
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A sovereign wealth fund manager is analyzing country risks associated with investing in the bonds of issuers in both developing and developed markets. The manager assesses the default risk of sovereign bonds as well as the country risk reflected in corporate bonds. Assuming all else is held constant, which of the following statements would most likely be correct for the manager to make?
A
A global economic downturn will generally have less impact on developing countries than on developed countries.
B
Countries that have larger commitments to provide health care and pay pensions to their citizens will have higher default risk than equivalent countries that do not.
C
Countries with a much higher government debt-to-GDP ratio will generally have a lower default risk than countries with a lower debt-to-GDP ratio.
D
Sovereign defaults by developing countries will typically result in no recovery for investors holding bonds issued by that country.
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