Emerging debt in a rising interest rate environment
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As a fixed income asset class with relatively high duration, sovereign emerging debt is sensitive to interest rates. But is there anything else we can say?

The yield on a sovereign debt portfolio can be broken down into two main components - the risk-free yield (US Treasury of similar duration) plus a credit spread. Therefore, it is clear that, ceteris paribus, a rise in the US Treasury (UST) yield will lower the price of the portfolio via this risk-free yield component. But need it be the case that a rise in the UST yield also affects the credit spread of the emerging debt portfolio?

Thus far in 2018, we have witnessed exactly this phenomenon. Rising UST yields have been associated with rising credit spreads (56 basis points through May 31). But are there historical or theoretical underpinnings that justify this move? This will be the subject of this paper.

In Figure 1, we segment the credit spread of the EMBIG benchmark into two components. The smaller component is the pure credit risk premium. Think of this as the spread, in basis points, required to compensate a risk-neutral investor for credit losses due to default.

We calculate this using an algorithm we developed that uses ratings transition matrices provided by the rating agencies to calculate default probabilities for countries in the benchmark. When combined with other assumptions, including recovery values in the event of default, we can calculate this 'expected credit loss spread'.

Notice that this is the smaller of the two components of the overall credit spread. This is because the average credit quality of the benchmark is fairly stable over time, and the historical experience is that sovereign defaults are thankfully rare. There is, on average, about one sovereign default per year.

Moreover, our internal analysis of sovereign defaults over the past 20 to 25 years reveals that they tend to be idiosyncratic and uncorrelated. Therefore, in a benchmark with more than 60 countries, there is a strong diversification benefit (from default risk, anyway). Overall then, it is intuitive to us that this spread component should be relatively small and relatively stable over time. Currently it stands at about 114 basis points.

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