Factor investing in hard currency emerging market debt

Emerging market debt (EMD) has grown into an important asset class. Sovereign debt (i.e. bonds issued by governments) represents the largest segment of this market and roughly half of this segment is issued in hard currency (HC), notably the United States Dollar (USD). The yield on hard currency emerging market debt (HC EMD) is higher than the yield on US government bonds. The spread, the difference in yield between the emerging market bonds and US treasuries, compensates investors for the elevated credit risk associated with emerging governments. Spreads vary substantially across countries and over time (McGuire & Schrijvers 2003) and this variation offers opportunities for investors.

Although there is a wide body of literature on the determinants of HC EMD spreads, there is only scant literature on their predictability. This internship is intended to fill this gap and identify factors that investors can use to predict HC EMD spreads and ultimately beat the market. When looking for these factors we see two dimensions that are relevant. First of all, HC EMD is issued by governments and this suggests looking at factors relating to the macro-economy and political risk. Secondly, HC EMD is similar to corporate debt because of the credit risk and the spread (after all, a country cannot create foreign currency and thus may default on its USD denominated debt). This suggests borrowing factors that are relevant for corporate credits and to see whether they can be applied to HC EMD.

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Audzeyevaa and Fuertes (2018) “On the predictability of emerging market sovereign credit spreads”, Journal of International Money and Finance 88, pp.140-157

Brooks, Richardson and Xu (2020) “(Systematic) investing in emerging market debt”, SSRN working paper

Comelli (2012) “Emerging market sovereign bond spreads : Estimation and back-testing”, IMF Working Papers 2012/212

Duyvesteyn and Martens (2015) “Forecasting sovereign default risk with Merton’s model”, Journal of Fixed Income 25(2), pp. 58-71

Duyvesteyn, Martens and Verwijmeren (2016) “Political risk and expected government bond returns”, Journal of Empirical Finance 38A, pp.498-512

Jostova (2006) “Predictability in emerging sovereign debt markets”, Journal of Business 79(2), pp.527-565

McGuire and Schrijvers (2003) “Common factors in emerging market spreads”, BIS Quarterly Review, pp.65-78