Spreads on government bonds are at their simplest an expression of differences in the level of a country’s development. This single number encompasses; risk, expected return and other characteristics of a state or region. These collective expressions also reflect factors such as bond supply and demand, political risk, economic risk, expected inflation, solvency and expected changes in the exchange rate. In this two part article I will focus mainly on hard currency Emerging Market Debt (EMD), which is somewhat more interesting to developed market investors. I will also examine US Federal Reserve policy and other more domestic influences such as fiscal and non-fiscal factors, which affect movements in the spreads on emerging market government bonds. I believe identifying the impact of fiscal influences on spreads can be of great importance for the conduct of fiscal policy going forward, thus optimising fiscal policy as to avoid negative impacts on yields. I will also look at what lessons can be learnt from various emerging market sovereign debt crises and the risk associated with EMD.
The US housing collapse and the subsequent global financial crisis forced investors to rethink their long held distinctions between emerging markets and developed markets. Emerging markets have traditionally been seen as a rather obscure sector of the global bond market. It’s my belief that after the financial crisis of 2008, three underpinnings helped the sector to emerge from obscurity (1) Good risk-adjusted returns 2) the diversification prospects and (3) the growing share of EMD relative to developed market debt. As capital incomes in emerging market increase, we anticipate a corresponding deepening in local bought and denominated sovereign debt.
The structure of deficit financing (domestic and foreign) has been a discussion of many an academic journal. While there have been many papers written on the topic, the nexus between the two remains inconclusive. Overall, the majority of findings demonstrate the relevance of monetary policy in supporting economic growth, mainly in financially developed economies with independent central banks. However, the relationship tends to weaken in developing economies with underdeveloped financial markets that are weakly integrated with global markets. It is my belief that monetary policy matters for growth both in the short- and long-run, despite the prevailing ambiguous relationship. Monetary policy and economic growth theories have evolved considerably over time. Economic growth theory and monetary theory predates the classical Quantity Theory of Money. However, modern theories only came to the fore in the 1930s, with Keynesian Liquidity Preference Theory. Liquidity Preference Theory suggests that investors demand a higher return, which carries greater risk. According to the theory, investors should be compensated for the term of their securities, with short-term maturities yielding lower than longer dated ones.
Sovereign defaults are not only limited to emerging markets and frontier economies. The first country to default on its debts was Greece in 377BC. Spain has defaulted the most with a string of defaults through 1550 to the 1800s. In Spain’s case, economists used the quantity theory to link an influx of Latin American gold to a relatively high annual inflation rate of 1-1.5% (low by modern standards but high at the time given prevailing momentary policy). Prices subsequently rose six fold during the following 150 years, however, Spain, unlike other European countries, did not debase their currency until 1599.
In the last couple of decades the focus has been on emerging market economies with crises such as the Latin American debt crisis at the beginning of the 80’s, the Mexican events of 1994-95 and later events such as the Russian crisis in 1998, Ecuador in 1999, Argentina 2001 and Uruguay in 2003, Although sovereign defaults are a larger risk in emerging market debt I do not believe that all emerging markets should be tarred with the same brush. While some might warn of contagion in the EMD, as you can see from the graph below, Thailand, along with many other Asian countries, have been relatively unaffected by the recent problems in Turkey and Argentina.
Emerging market economics typically exhibit a procyclical fiscal policy, public expenditure rises in economic expansions, while tax rates rise in bad times. In addition to this, the business cycles of these economies are usually characterised by a countercyclical default risk. Gavin and Perotti (1997) document that fiscal policy is procyclical in Latin America. Talvi and Vegh (2000) argue that far from being a particular feature of Latin American countries, procyclical fiscal policy appears to be the norm among developing economies. While G7 economies, fiscal policy follows more of an acyclic cycle which simply means there is no cycle. Kaminsky, Reinhart and Vegh (2004) review the empirical evidence on the procyclicality of economic policy, analysing countries grouped by income level. They found that OECD countries seemed to implement either countercyclical or acyclical fiscal policies, while low and middle income countries seem to implement procyclical fiscal policies. Developing economies exhibit more volatile business cycles and are more crisis prone than developed economies.
Since sovereign debt contracts are unenforceable and the government has the option to default on the outstanding debt, what is the incentive for the countries to pay? In cases of default, the economy experiences an output loss and is temporarily excluded from international credit markets. The JPMorgan Core Emerging Market Bond Index, (which tracks dollar-denominated debt) has climbed over 1% since the end of 2017. At the time of writing, the yield hit 6.7%, a level not seen since 2009. While in 2016 the yield did reach 6.5%, it’s a sign of weakness playing out in these markets. Several factors have played into the weakness of this debt. One major factor is the tightening of monetary policy by the US Federal Reserve. With the five-year US treasury notes hovering around 2.7%-2.9%, and ten-year notes yielding just below 3%, investors don’t see the risk premium as substantial enough to compensate them for holding EMD over US government debt.
Although EMD has been inherently more risky than developed market debt, investors have been rewarded for this as represented in the graph above. Below I have attached a histogram of the monthly return over the past five years for Emerging Market USD denominated debt (EMD USD), US TREASURES, US CORPORATE and US HIGH YIELD and the descriptive characteristics of the data. Something I found interesting is the negative kurtosis on the EM USD which has lighter tails than a normal distribution. This is generally unusual in financial markets and indicates that large gains or large losses tend to be unlikely. Of course the sample size used does make the data rather statistically insignificant nevertheless it is an interesting observation. As evidenced by the chart, US dollar denominated EMD has produced similar returns to US HIGH YIELD debt over the period, with reduced volatility and superior diversification benefits versus other asset classes. One other observation that can be made is that the standard deviation (spread of returns) of EMD USD (1.313%) vs US HIGH YIELD (1.442%) is lower, indicating that which means US HIGH YIELD is a more volatile asset.
With US HIGH YIELD having a mean monthly return over the past 5 years of (0.46%) and EM USD lower at (0.36%), the case could be made that high yield investors have been compensated for the extra risk they are taking. While that might be true, it is important to bear in mind that because US HIGH YIELD has positive skewness, it is over estimating the mean, while EMD USD is under-estimating the mean. Overall I think there is a relatively strong case for EMD, especially when it is denominated in USD or any other hard currency. The second part of this article will follow in about 6 weeks’ time and will continue to look at the EMD with more examples and an in-depth look at recent events in EMD.
Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.