Contents

Returns and risks

Prior to the Mexican default in the early 1980’s, most sovereign emerging market debt was a product of bank financing. The establishment of so-called Brady bonds [2] during the ensuing Mexican debt restructuring transferred emerging market debt to the public bond markets. The data history of emerging market bond investment is therefore brief. Available data begins in 1991 with the creation of the JP Morgan EMBI index, [3] an index of U.S. dollar emerging market bonds.

As Erb, Harvey, and Visconti [4] noted in 1997, emerging market bond returns from 1991-1997 outperformed the performance of the S&P 500 index. They also noted that this short initial return sequence showed high volatility and negative skewness, suggesting that downside risk was high, although not realized in the short term returns data. This insight was proved correct, as the Asian Contagion financial crisis in 1998 produced negative returns in 1998. Returns from 2000-2010 have been somewhat less volatile (as measured by standard deviation, see table below), but the asset class has retained its quality of negative skewness. Erb, Harvey, and Visconti state:

One difficulty with measuring skewness is that it likely changes through time. Therefore looking at past data may give no indication of future expected skewness. This is the so called “peso problem” in economic theory. Looking at past currency movements, you may see little variation in rates during a managed float regime. However, there is a probability of a devaluation that you cannot detect from looking at past data. This is just the definition of negative skewness.

Emerging market bonds are subject to three major risks:

• Interest rate risk. Most emerging market bond portfolios hold intermediate to long term bonds. Thus the portfolios have high durations and high interest rate risk: bond principal will fluctuate with changes in interest rates.
• Currency risk. The marketplace is now dominated by local currency bond issues. These bonds bear currency risk, the risk that changes in exchange rates can result in gains or losses.
• Sovereign risk. The risk that a country will default on its external non-local currency debt. Closely associated with this risk is inflation risk affecting local currency bonds, where a bond’s principal value can effectively be destroyed by high inflation.

Table 1. Emerging Market bond index returns [5]

Yields

In accordance with the high historical risks associated with emerging market bonds, investors have historically demanded high yields as compensation for bearing risk. Yields, of course, fluctuate with economic fundamentals, as well as with investor sentiment. Emerging market bond interest rates are often measured against risk free debt instruments, resulting in what is known as a yield spread. The adjacent figure shows yield spreads for the period 1993-2010 between the US dollar denominated JP Morgan EMBI Index and comparable US treasury bonds. The figure also traces the level of credit quality within the EMBI index.

Correlation

The Vanguard Institutional white paper, Global fixed income: Considerations for U.S. investors. provides correlation data between emerging market bonds and major asset classes for the period between 2002-2010. Over this period, dollar based emerging market debt had higher correlations (between 0.55 and 0.65) with US stocks, developed market stocks, and emerging market stocks, as well as with US bonds; and lower correlations (between 0.30 and 0.45) with hedged and unhedged international bonds. Local currency bonds had lower correlations (0.30) with US stocks, developed market stocks, and emerging market stocks; and higher correlations (between 0.45 and 0.60) with US bonds, hedged international bonds, and unhedged international bonds. [6]

Erb, Harvey and Visconti note that emerging market bond correlations with other asset classes are subject to shifts, depending on the state of the economy and markets. Thus during the 1998 Asian Contagion currency crisis, emerging market bonds were highly correlated with US stocks, emerging market stocks, and high yield bonds, all of which fell in price, and were negatively correlated with US treasuries, which rose in price. [7]

Default risk

Bond defaults and restructurings have a long history. Prior to the nineteenth century, defaults were common among European nation states. With national independence movements beginning in the early nineteenth century and continuing to this day, bond defaults and restructurings became prevalent among these new emerging markets.

Defaults and restructurings tend to occur in clusters. Historical clusters include: [8]

• 1824-1834
• 1867-1882
• 1890-1900
• 1911-1921
• 1931-1940
• 1976-1989
• 1998-2004

The following table, based on the Reinhart, Rogoff, and Sevastano paper, Debt intolerance. provides historical default and restructuring data (1824-2001). The table also shows the amount of time countries have spent under default or restructuring, which has often been considerable. Reinhart, Rogoff, and Sevastano also note that defaulting nations have also frequently been high inflation nations, having experienced inflation at or above 40% per month.

Table 2. External Debt Defaults and Country Risk: 1824-2001 [9]