Emerging Market Local Currency Bond Market, Too Risky to Invest?

Küçük, Ugur N. (2009): Emerging Market Local Currency Bond Market, Too Risky to Invest?

Abstract

Over the last decade, local currency emerging market (EM) debt has been developing to become an attractive and complementary investment category as many EM countries have been successful to reduce currency mismatches and maturity problems by implementing sound fiscal and monetary policies. Analyzing the period from 2002 to July 2009, we show that the local currency EM debt investments provide significant additional alpha and diversification to traditional bond portfolios. In particular, first, EM local currency bond returns are less correlated to the US stock market, treasury and high-yield bond markets, and global risk premia compared to the a case of EM equity and US dollar-denominated bond markets. Second, yields and excess returns on local currency debt depend largely on expected depreciation of the exchange rate against US dollar, while excess returns on dollar-denominated EM debt are for the most part compensation for bearing the global risk. Third, EM sovereign local currency bond returns beat other emerging and mature market asset classes by providing higher risk adjusted excess returns and diversification. In light of our findings, we suggest that the development of local currency bond markets in EM countries could contribute to global financial stability by reducing currency mismatches and reliance on foreign currency debt, which in turn is linked to growth and poverty reduction.

• Item Type: MPRA Paper
• Language: English
• Keywords: Sovereign Bond Market; Local Currency Bonds; Emerging Markets; Bond Portfolio; Excess Returns
• Subjects: G - Financial Economics > G1 - General Financial Markets; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

BIS, 2007, Financial stability and local currency bond markets, CGFS Papers 28.

BIS , 2008, International banking and _nancial market developments, BIS Quarterly Review June 2008.

Bordo, Michael D., Christopher M. Meissner, and Angela Redish, 2005, How original sin was overcome: The evolution of external debt denominated in domestic currencies in the united states and the british dominions, 18002000, University of Chicago Press.

Broner, Fernando, R. Gaston Gelos, and Carmen Reinhart, 2004, When in peril, retrench: Testing the portfolio channel of contagion, Federal Researve Bank of San Francisco Working Paper No. 2004-28.

Bulow, Jeremy, and Kenneth Rogof, 1989, Sovereign debt: Is to forgive to forget?, American Economic Review 79, 43{50.

Bunda, Irina, A. Javier Hamann, and Subir Lall, 2004, Correlations in emerging market bonds: The role of local and global factors, Emerging Markets Review 10.

Burger, John D., Francis E. Warnock, and Veronica Warnock, 2009, Global financial stability and local currency bond markets, Working Paper.

Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier, 2008, Financial crash, commodity prices and global imbalances, NBER Working Paper.

Campa, Jose, and Nuno Fernandes, 2006, Sources of gains from international portfolio diversifica- tion, Journal of Empirical Finance 13, 417{443.

Campanaro, Alessandra, and Dimitri Vittas, 2004, Greco-roman lessons for public debt management and debt market development, World Bank Policy Research Paper No. 3414.

Chamon, Marcos, 2003, Why cant developing countries borrow from abroad in their currency?, International Monetary Fund.

Claessens, Stijn, Daniela Klingebiel, and Sergio Schmukler, 2003, Government bonds in domestic and foreign currency: The role of macroeconomic and institutional factors, CEPR Discussion Paper No. 3789.

Co., JPMorgan Chase &, 2006, Global market outlook strategy.

Cochrane, John H., and Monika Piazzesi, 2005, Bond risk premia, American Economic Review 98, 138-160.

Das, Sanjiv, and Raman Uppal, 2004, Systemic risk and international portfolio choice, Journal of Finance 59, 2809-2834.

De Santis, Giorgio, and Bruno Gerard, 1997, International asset pricing and portfolio diversi_cation with time-varying risk, Journal of Finance 52, 1881-1912.

Dooley, Michael P., and Lars E. O. Svensson, 1994, Policy inconsistency and external debt service, Journal of International Money and Finance 13, 364-374.

Duffie, Darrell, 1999, Credit swap valuation, Financial Analysts Journal January February, 73-87.

, Pedersen Lasse H., and Kenneth J. Singleton, 2003, Modeling sovereign yield spreads: A case study of russian debt, Journal of Finance 58, 119-159.

Erb, Claude B, Campbell R. Harvey, and Tadas E. Viskanta, 1996, The inuence of political, economic, and _nancial risk on expected _xed-income returns, Journal of Fixed Income pp. 7-31.

Erb, Claude B. 1997, Emerging market bonds: A global perspective, proceedings of the association for investment management and research, Financial Analysts Seminar, Northwestern University, July 24.

Erb, Claude B., 1999, New perspectives on emerging market bonds, The Journal of Portfolio Management Winter, 83-92.

Fabozzi, Frank J., Lionel Martellini, and Philippe Priaulet, 2006, Advanced Bond Portfolio Man- agement, Best Practices in Modeling and Strategies, (Wiley & Sons, Inc.,: Hoboken, New Jersey).

Fama, Eugene F., and Kenneth R. French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3-56.

French, Kenneth, and James Poterba, 1991, Investor diversi_cation and international equity markets, American Economic Review 81, 222-226.

Glick, Reuven, and Andrew Rose, 1999, Contagion and trade: Why are currency crises regional?, Journal of International Money and Finance 18, 60317.

Goetzmann, William, Lingfeng Li, and Geert Rouwenhorst, 2005, Long-term global market correlations, Journal of Business 78, 1-31.

Gracio, De Alessi, Glenn Hoggarth Cristiana, and Jing Yang, 2005, Capital ows to emerging markets: Recent trends and potential _nancial stability implications, Bank of England pp. 94-102.

Griffin, John, and G. Andrew Karolyi, 1998, Another look at the role of the industrial structure of market for international diversification strategies, Journal of Financial Economics 50, 351-373.

Grubel, Herbert, 1968, Internationally diversified portfolios: Welfare gains and capital ows, Amer- ican Economic Review 58, 1299-1314.

Hauner, David, and Manmohan S. Kumar, 2005, financial globalization and fiscal performance in emerging market, IMF Working Paper 05/212.

Heston, Steven, and K. Geert Rouwenhorst, 1994,, Does industrial structure explain the bene_ts of international diversification?, Journal of Financial Economics 36, 3-27. 23

Hostland, Doug, and Philippe Karam, 2005, Assessing debt sustainability in emerging market economies using stochastic simulation methods, IMF Working Paper 05/226.

Hull, John, and Allen White, 2001, Valuing credit default swaps I: No counterparty risk journal of derivatives, Journal of Derivatives.

IMF, 2006, Financial stability report, World Economic and Financial Surveys April.

IMF, 2009, Global _nancial stability report, World Economic and Financial Surveys April.

IMF, April-2008, De facto classification of exchange rate regimes and monetary policy frame- works, Country Reports, April.

Jeanne, Olivier, 2004, Debt maturity and the international financial architecture, IMF Working Paper 04/137.

Kaminsky, Graciela, Richard Lyons, and Sergio Schmukler, 2004, Managers, investors, and crises: Mutual fund strategies in emerging markets, Journal of International Economics 64, 113-34.

Kucuk, Ugur N., 2010, Non-default component of sovereign emerging market yield spreads and its determinants: Evidence from credit default swap market, Journal of Fixed Income, Spring 2010, Vol. 19, No. 4: pp. 44–66.

Lessard, Donald, 1974, World, national and industry factors in equity returns, Journal of Finance 29, 379-391.

Levy, Haim, and Marshall Sarnat, 1970, International diversification of investment portfolios, American Economic Review 60, 668{675.

Longstaff, Francis A., 2004, The ight to liquidity premium in US treasury bond prices, Journal of Business 77, 51526.

Longstaff, Francis A, Sanjay Mithal, and Eric Neis, 2005, Corporate yield spreads: Default risk or liquidity? new evidence from the credit default swap market, Journal of Finance 60, 221-2253.

Longstaff, Francis A., Jun Pan, Pedersen, Lasse H., and Kenneth J. Singleton, 2008, How sovereign is sovereign credit risk?, NBER Working Paper 13658.

Mehl, Arnaud, and Julien Reynaud, 2005, The determinants of domestic original sin in emerging market economies, ECB Working Paper No. 560.

Pan, Jun, and Kenneth J. Singleton, 2008, Default and recovery implicit in the term structure of sovereign CDS spreads, Journal of Finance 63-October, 2345-2384.

Remolona, Eli, Michela Scatigna, and Eliza Wu, 2007, The dynamic pricing of sovereign risk in emerging markets: Fundamentals and risk aversion, Working paper, The Bank for International Settlements.

Rozada, Martin, and Eduardo Yeyati, 2005, Global factors and emerging market spreads, Working paper, Universidad Torcuato Di Tella.

Sachs, Goldman, 2005, Global Economics Weekly November30.

Sharpe, William. F., 1966, Mutual fund performance, Journal of Business 39, 119-138.

Sharpe, William. F., 1994, The sharpe ratio, Journal of Portfolio Management 21, 4958.

Solnik, Bruno, 1974, 1974, Why not diversify internationally rather than domestically?, Financial Analysts Journal 30, 48-54.

Tirole, Jean, 2002, Financial Crises, Liquidity, and the International Monetary System (Princeton University Press: Princeton, New Jersey).

White, Halbert, 1980, A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica 48, 817-838.