Investors have had a ferocious appetite for emerging market
local-currency bonds since the outbreak of the global financial
crisis, with yields falling 2 percentage points since mid-2007.
|Erik Lueth, Senior Asia Economist,
Some have been attracted by the sounder debt metrics
compared with mature economies.
Central banks and sovereign wealth funds, in particular,
have used emerging market bonds to reduce their huge exposures
to dollar-denominated debt.
Others have sought higher returns from yields that were on
average 300 basis points higher than those on equivalent
US Treasury yields during January 2007 to March 2013,
according to Bloomberg.
This demand has not been matched with unlimited supply
because emerging market government bond sales are restricted by
economic factors. At the end of 2012, the outstanding stock of
emerging market local-currency bonds was $5.6 trillion, less
than half of the $12 trillion debt stock in
Japan and only a third of the $16.5 trillion bond pool in
the US, according to Bank of International Settlements.
Yields on ten-year emerging market bonds have fallen
sharply, by 1 percentage point in the past year to an average
4.7 per cent and down from 6.8 per cent in mid 2007, according
to Bloomberg data. This is due to falling US debt yields, which
create cross-border arbitrage opportunities and cuts to
emerging-market policy rates.
In emerging Europe and Latin America, average yields have
dropped even more than the global average, to 4.2 per cent and
6.4 per cent respectively. Emerging Asia debt today sports
lower yields than several advanced European economies, with
yields dropping to 3.4 per cent, compared to 4.3 per cent in
Italy and 4.7 per cent in Spain, Bloomberg data shows.
While weak global economic prospects and loose monetary
conditions are rightfully positive for emerging market bond
prices, and in turn have pushed down yields, the rally seems to
have gone too far.
Our analysis of the economic factors that generally
determine 10-year emerging market debt yields against the
actual yields from January 2007 to March 2013 suggests that
emerging market bonds are in fact fairly valued. It shows
actual yields have moved broadly in line with those predicted
by our estimated economic relationship.
This analysis involved breaking down bond yields into the
contributions of inflation, monetary stance, fiscal position,
global yields, and global stress. We found these factors
explained 90 per cent of yield variation over time based on a
regression study between January 2007 and March 2013.
However, we believe this analysis is somewhat flawed because
the estimation, like any estimation, is designed to minimise
the gap between actual and predicted bond yields and therefore
has a bias towards finding fairly-valued bonds.
To avoid this bias, we ran an out-of-sample forecast using
data only up to March 2012. By this measure, emerging market
yields are 0.6 percentage points too low, which suggests
ten-year bonds are overvalued by about 5 per cent.
In the event of a sell-off triggered by the US monetary
tightening moving closer, losses on emerging market debt could
in fact be much higher than 5 per cent.
Bonds look particularly overvalued in emerging Europe, where
average yields are about 2 percentage points lower than in
Latin America, where they are 4.5 per cent, despite the two
regions having broadly similar economic fundamentals. In
addition, yields in emerging Europe are 80 basis points lower
than we would expect based on our out-of-sample analysis of
economic factors against bond yields. Latin American bonds,
with yields at an average 6.7 per cent, still look attractive
to us because our fundamental analysis suggests yields of 5.2
In Asia, Indian bonds have the highest yields among
emerging markets at about 8 per cent, which seems justified by
the country performing poorly on nearly every economic measure.
Public debt and the deficit amount to 67 per cent and 5 per
cent of gross domestic product respectively, compared to 44 per
cent and 0.8 per cent for the rest of the region. Inflation
expectations are 8.8 per cent versus 3.4 per cent for the rest
of Asia and at 7.5 per cent the policy rate is exceptionally
high. Indian bonds therefore look fairly priced.
Indonesian debt, yielding 5.6 per cent, appears to be
undervalued with overall economic fundamentals, in particular
debt to gross domestic product and expected deficit,
outperforming those of Thailand and Malaysia, where bond yields
are about 210 basis points lower. Taiwan also looks overpriced,
with ten-year bonds at 1.3 per cent. Economic fundamentals are
broadly in line with Korea’s, yet yields are 140
basis points lower, our out-of-sample study shows.
With all things considered, based on our analysis, we expect
to see a sell-off in emerging market bonds in the
not-too-distant future. Analysing the overvaluation of the debt
and any wider impact is an important exercise for investors and
issuers to consider now.
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