Risks in Emerging Market Bonds

The history of emerging and/or frontier market government borrowers began slowly with only a few nations. It has since grown into a large and distinct market. Numerous crises from Latin America, Asia, and Europe have plagued the market throughout its development.

Investing in emerging market debt involves similar risks as investing in more developed economies’ debt. Among others, these risks include interest rate changes, currency movements, and the potential for defaults. In addition, investing in emerging market debt poses risks that are less significant in developed markets. These risks fall roughly into two categories:

(1) Economic or “ability to pay.”

(2) Political/legal or “willingness to pay.”

The following characteristics typify higher-risk emerging market debt:

• Higher wealth concentration.
• Greater dependence on cyclical industries, e.g., commodities, and low pricing power in world markets.
• Restrictions on trade, capital flows, and currency.
• Poor fiscal controls and monetary discipline.
• An insufficient fiscal and monetary control system.
• Less educated and inadequately skilled workforce; poor physical infrastructure; lower level of technological advancement.
• Dependence on foreign borrowing, usually in hard currencies.
• Underdeveloped and small financial markets.
• Vulnerability to volatile capital flows.

Analysts should also consider the following:

• Fiscal deficit to GDP: A constant ratio above 4% is likely a cause for concern.
• Debt-to-GDP ratio: Exceeding 70%–80 is a sign of vulnerability for an emerging market.
• An annual real growth rate: Less than 4% suggests that an emerging market is slowly catching up with more advanced economies only slowly.
• Current account deficits: Greater than 4% of GDP probably indicates a lack of global competitiveness.
• Foreign debt: Greater than 50% of GDP or greater than 200% of current account receipts is also a sign of danger.
• Foreign exchange reserves: Less than 100% of short-term debt is risky, whereas a ratio greater than 200% is ample.
• Access to support from international agencies such as the International Monetary Fund (IMF) or the World Bank.

Political and Legal Risks/Willingness to Pay

International fixed-income investors may be unable to collect payment for various reasons, most of which stem from political instability, corruption, or weak property rights. History may be the best place to answer many questions pertinent to bond investors. Factors to consider include:

• Past violations of property rights.
• Stability of the political institutions.
• Effectiveness of the judicial system.

Question

Which of the following aspects of an economy would most likely reduce the confidence of a fixed-income investor?

1. Diverse tax base.
2. Less concentration of wealth.
3. Greater dependence on specific industries.

Solution

The correct answer is C.

Greater dependence on specific industries would leave fixed-income investors less confident. This is because the industry upon which investors depend poses a substantial risk. If the industry experiences turmoil, there is little buffer (diversification) to save the economy.

A is incorrect. A diverse tax base is generally considered a positive factor for fixed-income investors. A diverse tax base means that the government has multiple sources of revenue, which can help to reduce the risk of default on its debt obligations. This, in turn, can increase the confidence of fixed-income investors.

B is incorrect. It is generally considered a positive factor for fixed-income investors. When wealth is less concentrated, there is a larger middle class with more disposable income. This can lead to increased economic stability and growth, increasing the confidence of fixed-income investors.

Asset Allocation: Learning Module 2: Capital Market Expectations – Part 2 Forecasting Asset Class Returns; Los 2(b) Discuss risks faced by investors in emerging market fixed-income securities and the country risk analysis techniques used to evaluate emerging market economies