Emerging and advanced market divide impacts sovereign risk

Market Realist

An investor's guide to sovereign risk for pricing bond returns (Part 10 of 10)

(Continued from Part 9)

Emerging and advanced market divide

The European debt crisis, comprising the Portugal, Ireland, Italy, Greece and Spain (or PIIGS) nations in 2009–2012, forced many sovereign debt theories to be reassessed.

The first lesson from the crisis was undoubtedly that developed market (EFA) government debt was essentially risk-free.

Greece reached agreement after agreement with its creditors from 2009–2012 in order to avoid a full-blown default and stay in the Eurozone. This forced many creditors to let go of liabilities worth billions to enable the country to make good on the balance.

Contagion effect

The importance of contagions, or investor flows as a group, has been demonstrated in 2014. The Fed’s taper of asset purchases in December, 2013 and January, 2014 produced one such contagion. The drying up of market liquidity resulted in investors exiting emerging market stocks (VWO) and bonds regardless of underlying fundamentals.

Indexation of asset classes

Another relevant factor is economic contagion. A financial or economic crisis in a foreign country could affect other countries included in the asset class or in the geographic area. Bond spreads could widen for other affected countries, despite the fact that their economic fundamentals were actually improving. This is especially true for emerging market debt. It’s common for countries to be lumped together in a single asset class. There aren’t too many country-specific options available.

Why global financial flows matter

Global financial flows are more interconnected than ever. Sophisticated investors have international portfolios. They base their investment decisions on a number of factors including stock market returns (IVV) in their home country, returns on alternate asset classes, such as high-yield bonds (JNK), gold (GLD) and real estate. In this case, the risk premium associated with a country’s debt is only partly related to the economic fundamentals and fiscal balances prevailing in the country.

You can read about recent trends in the U.S. investment-grade bond market in the Market Realist series, Overview: High-grade borrowers are upbeat about market conditions.

 

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