Type I and Type II Errors in Manager S ...
Candidates may remember their inferential statistics training from CFA Level I. This reading... Read More
International effects can influence a fixed-income portfolio, even if they aren't immediately apparent. This is because numerous businesses, and increasingly so, derive a portion of their revenues and costs from foreign origins.
The emerging market corporate bond universe has grown significantly, rivaling the size of the US high-yield credit market. This presents both new risks and opportunities for investors.
Several differences distinguish credit markets in EM countries from those in developed countries:
These factors shape the unique landscape of EM credit markets.
Liquidity challenges are prevalent across credit markets, though the extent of illiquidity differs worldwide. The US credit market boasts high liquidity due to market value, numerous participants (issuers, dealers, and investors), active bond issuance, and advanced trade reporting systems.
Emerging markets, however, face notable liquidity limitations. Infrequent bond trading in these markets increases premiums for holding emerging market credit securities.
Currency risk becomes more significant when interest rates are low. When investment-grade credit returns in the local currency are not substantial, currency movements can quickly negate a non-domestic credit investor's expected return. To manage currency risk in credit portfolios, a common approach is to hedge foreign exchange exposures. Global credit portfolio managers frequently employ currency swaps to hedge these exposures alongside geographic diversification.
Legal risk poses challenges to international credit portfolio managers due to variations in regulations and laws across different countries. Bankruptcy laws in various nations can be intricate, and investors without comprehensive knowledge might experience lower recovery rates in case of bond defaults. In the United States, credit investors deal with a unified federal bankruptcy law, whereas emerging markets (EM) present diverse scenarios. In specific less developed markets, creditors might encounter legal systems influenced by government officials and equity holders, adding to the complexity of legal risk.
Question
Which of the following financial ratios is the most suitable for evaluating the liquidity position of an emerging market sovereign issuer of US dollar-denominated bonds in terms of its ability to make interest payments over the next 12 months?
- Ratio of Government Budget Deficit to GDP.
- Ratio of External Debt to GDP.
- Ratio of Currency Reserves to GDP.
Solution
The Correct Answer is C.
The most suitable financial ratio for evaluating the liquidity position of an emerging market sovereign issuer of US dollar-denominated bonds, specifically in terms of its ability to make interest payments over the next 12 months, is the “Ratio of Currency Reserves to GDP.” This ratio directly measures the availability of foreign currency reserves to meet foreign-denominated bond payments, including interest, and is a critical factor in assessing liquidity for such obligations.
A and B are incorrect. They are essential financial indicators but are more relevant for assessing fiscal health and long-term debt sustainability rather than short-term liquidity and immediate interest payment capacity.
Reading 22: Fixed Income Active Management: Credit Strategies
Los 22 (i) Discuss considerations in constructing and managing portfolios across international credit markets