Emerging Market Hard Currency Bonds: How Systematic Selection Actually Works

Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. Publisher: John Wiley & Sons, 2022 ISBN: 9781119900139

Emerging market bonds are a massive asset class that most people know almost nothing about. Chapter 7 of Richardson’s book focuses on hard currency bonds, meaning USD-denominated bonds issued by emerging market countries. And it turns out that the same systematic investment themes we saw for corporate bonds also work here.

The Size of the Opportunity

The total emerging market fixed income universe is roughly $29.6 trillion USD. That is not small. Local currency bonds make up about 82 percent of that, and the remaining 18 percent is what we are calling “hard currency” or external debt. China alone accounts for about 52 percent of all emerging market bond issuance.

But here is the thing. The index that most investors actually use as a benchmark, the JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD), only covers about $1.15 trillion USD. Countries get included only if their Gross National Income falls below a certain threshold, and individual bonds need at least $500 million face value, decent liquidity, and at least 2.5 years to maturity. So we are looking at the liquid, investable slice of a much larger pie.

Who Issues These Bonds?

The EMBIGD includes both sovereign bonds (issued directly by governments) and quasi-sovereign bonds (issued by entities fully owned or guaranteed by the government). As of late 2020, the index held 861 individual bonds. Of those, 546 were sovereign and 315 were quasi-sovereign, spread across 200 distinct entities from 73 countries.

The number of issuers has grown a lot. Back in 2002, the index had a market cap of $203 billion USD and around 140 bonds. By 2020 it had crossed $1 trillion with over 750 bonds. The median sovereign issuer has about four bonds outstanding, and the median quasi-sovereign issuer has about two. So the investment opportunity set looks more like corporate bonds than government bonds in terms of breadth.

Credit Ratings and Risk

Most EMBIGD bonds are rated BBB or below, with a chunk not rated at all. Credit spreads move in a counter-cyclical pattern. When the economy struggles, spreads widen because the credit risk goes up. This is very similar to what happens with corporate bonds.

The key risk in a hard currency bond is that the issuing country cannot meet its USD obligations. Unlike local currency debt, where a government can always print more of its own money, hard currency debt has to be repaid in foreign currency. The sovereign cannot just run the printing press to solve this problem.

Over the 2002 to 2020 period, about 82 percent of return variation in these bonds came from the risky (credit spread) component and only 18 percent from the risk-free component. So spread risk is where the action is, and that is where security selection focuses.

The Four Investment Themes

Richardson applies the same framework from earlier chapters. Value, momentum, carry, and defensive. But data challenges mean the specific measures need to be adapted for emerging market sovereigns.

Value

For corporate bonds, you could use a structural model (distance to default) to figure out if a bond is cheap or expensive. For sovereign entities, that is much harder. How do you measure the “leverage” of a country? How do you get a precise volatility number?

Instead of forcing bad proxies into a structural model, Richardson uses a reduced form approach. He regresses credit spreads on two variables: the sovereign’s credit rating and the trailing 12-month volatility of the country’s equity market. The residual from that regression is the value signal. If a country’s spread is wider than what its rating and volatility would predict, it looks cheap.

Momentum

Momentum is measured as an equal-weighted combination of three six-month trailing returns: emerging market CDS returns, foreign exchange returns, and country equity returns. Positive returns across all three suggest continued outperformance.

You could also add fundamental momentum measures like changes in economic growth expectations or changes in sovereign indebtedness. But the simple price-based version already captures a lot.

Carry

This one is straightforward. Carry is the return you get if nothing changes. Higher-yielding assets tend to outperform lower-yielding ones, and this pattern shows up across many asset classes. The measure here is simply the five-year CDS spread at the start of each month. Higher spread means higher carry.

Defensive

Defensive captures the tendency of safer, lower-risk assets to deliver better risk-adjusted returns. Two measures go into this signal. First, forecasted inflation levels. A “better” sovereign targets and achieves low inflation. Second, a measure of indebtedness that compares assets (foreign reserves plus GDP grossed up by growth expectations) to debts (government external debt plus 50 percent of non-government external debt). Lower leverage and lower inflation both count as positive signals.

Do These Signals Actually Work?

Richardson tests long/short portfolios using five-year CDS contracts across about 25 emerging sovereign entities from 2004 to 2018. The results are pretty encouraging.

All four themes generate positive risk-adjusted returns individually. Sharpe ratios range from 0.34 for defensive to 0.68 for momentum. But the real payoff comes from combining them. An equally weighted combination of all four themes produces a Sharpe ratio of 1.11. That is much better than any single theme alone, and the reason is low pairwise correlations between the themes.

When you regress these theme returns against traditional market risk premia and equity style factors, the exposures are minimal. The combined portfolio’s returns are genuinely diversifying. They are not just repackaged beta.

Extensions Worth Knowing

The framework extends beyond just country selection. For sovereign issuers with multiple bonds, you can take positions along the maturity curve. You can define “country level” and “country slope” assets, similar to what was done for developed market government bonds.

There is also a large market for emerging market corporate bonds (the J.P. Morgan CEMBI index tracks about $500 billion USD of these). Research shows that systematic signals like value, momentum, and low risk work there too, though sourcing liquidity is more challenging and relationships with a broader set of trading counterparties become important.

The bottom line: systematic investing in emerging market hard currency bonds follows the same playbook as other credit-sensitive assets. The data challenges require some creative adaptations, but the fundamental insight holds. Diversified systematic signals can identify attractive risk-adjusted return opportunities.

This post is part of a series retelling Systematic Fixed Income: An Investor’s Guide by Scott A. Richardson.

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