Climate disaster risks, response capacities and sovereign bond yield spreads

From the perspective of extreme heat, this study integrates theoretical model expansion and empirical testing to investigate how climate disasters influence sovereign bond yield spreads and the effectiveness of climate response capabilities. Specifically, it first incorporates extreme heat into the rare disaster theoretical framework and extends the asset pricing model to provide theoretical evidence on how extreme heat influences sovereign bond yield spreads. Next, by utilizing an unbalanced panel of macroeconomic data for 49 countries over the period 1995–2018, this research applies the Least Squares Dummy Variable Corrected (LSDVC) approach for empirical tests concerning the effects, transmission channels, and response measures associated with extreme heat. The findings reveal that: (1) Extreme heat increases sovereign bond yield spreads across various nations, with the yield spread increase being more pronounced for developing countries; (2) The primary transmission channels through which extreme heat affects sovereign bond yield spreads include damage to agricultural production and repercussions on social stability, both of which raise the risk of sovereign default; (3) Enhancements in climate response capacity can effectively mitigate the increase in sovereign bond yield spreads caused by extreme heat. In response to extreme heat shocks, the business environment and social readiness of an economy all have significant alleviating effects. This study enriches the research on climate finance by concentrating on extreme heat and identifies the key sectors for responses to such climate events.