Emerging market sovereign bonds are overvalued and due a correction
Euromoney Limited, Registered in England & Wales, Company number 15236090
4 Bouverie Street, London, EC4Y 8AX
Copyright © Euromoney Limited 2024
Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement

Emerging market sovereign bonds are overvalued and due a correction

Emerging market sovereign bonds are overvalued by an average 5 per cent and are due a correction as US monetary easing nears its end. Emerging European debt looks most at risk of a sell-off, RBS analysis shows.

Erik Lueth, Senior Asia Economist, RBS

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. 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 per cent.

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. 

For more RBS Insight content, click here


The contents of this document are indicative and are subject to change without notice. This document is intended for your sole use on the basis that before entering into this, and/or any related transaction, you will ensure that you fully understand the potential risks and return of this, and/or any related transaction and determine it is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. You should consult with such advisers as you deem necessary to assist you in making these determinations. The Royal Bank of Scotland plc (“RBS”) will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser or owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on RBS for investment advice or recommendations of any sort. RBS makes no representations or warranties with respect to the information and disclaims all liability for any use you or your advisers make of the contents of this document. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not lawfully be disclaimed.

Where the document is connected to Over The Counter (“OTC”) financial instruments you should be aware that OTC derivatives (“OTC Derivatives”) can provide significant benefits but may also involve a variety of significant risks. All OTC Derivatives involve risks which include (inter-alia) the risk of adverse or unanticipated market, financial or political developments, risks relating to the counterparty, liquidity risk and other risks of a complex character. In the event that such risks arise, substantial costs and/or losses may be incurred and operational risks may arise in the event that appropriate internal systems and controls are not in place to manage such risks. Therefore you should also determine whether the OTC transaction is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances.

RBS and its affiliates, connected companies, employees or clients may have an interest in financial instruments of the type described in this document and/or in related financial instruments. Such interest may include dealing in, trading, holding, or acting as market-makers in such instruments and may include providing banking, credit and other financial services to any company or issuer of securities or financial instruments referred to herein.

RBS is authorised and regulated in the UK by the Financial Services Authority, in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US, by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in this document are made in compliance with an applicable exemption from the registration requirements of the United States Securities Act of 1933, as amended. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC (www.sipc.org) member and subsidiary of The Royal Bank of Scotland Group plc. Dubai International Financial Centre: This material has been prepared by The Royal Bank of Scotland plc and is directed at “Professional Clients” as defined by the Dubai Financial Services Authority (DFSA). No other person should act upon it. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Professional Client”. This document has not been reviewed or approved by the DFSA. Qatar Financial Centre: This material has been prepared by The Royal Bank of Scotland N.V. and is directed solely at persons who are not “Retail Customer” as defined by the Qatar Financial Centre Regulatory Authority. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Business Customer” or “Market Counterparty”.

The Royal Bank of Scotland plc acts in certain jurisdictions as the authorised agent of The Royal Bank of Scotland N.V.

The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB

Gift this article