Aurora Borealis
1 April 2014 CFA Institute Journal Review

Emerging Government Bond Market Timing (Digest Summary)

  1. Jakub M. Szudejko, CFA

Emerging market local currency government bonds are becoming increasingly popular among investors because of high yields and significant diversification benefits. Such timing strategies as bond momentum, equity momentum, and term spread prove to be effective in generating excess returns with these bonds, as they are with developed country bonds.

What’s Inside?

The authors investigate emerging market government bonds and their return sensitivity to such timing factors as bond momentum, equity momentum, and term spread. They explain how an investment strategy based on these three factors can outperform a passive strategy after transaction costs.

Because of the low correlations between emerging and developed markets, the authors suggest that the addition of emerging market government debt to fixed-income portfolios may improve the portfolios’ return and reduce their overall risk.

How Is This Research Useful to Practitioners?

Active investment strategies based on momentum and trade factors are commonly used to manage developed market bonds. The authors suggest that interest rates in emerging markets have similar drivers and that timing factors may also predict bond returns. They show that timing strategies are effective because interest rates tend to respond equally to inflation and growth dynamics.

The equity momentum strategy links past positive equity returns with negative government bond returns. The bond momentum strategy is based on the assumptions that the market is biased and reacts conservatively to new information. The term spread is related to yield curve steepness and represents the market’s expectation of yield changes.

Local currency emerging market bonds appear to offer significant diversification benefits. Although the correlation between US-dollar–denominated emerging market debt and US Treasury bonds is approximately 50%, the average correlation between the total return of local currency emerging market debt (in dollars) and the total return of US Treasury bonds is just 1%.

The authors show that bond momentum, equity momentum, and term spread can predict excess returns from emerging market bonds denominated in local currency by using a multifactor model to predict government bond excess returns.

Timing strategies appear to generate excess returns in emerging markets. Even after accounting for the lower liquidity and higher trading costs found in emerging markets, the authors discover that an investment strategy based on timing factors delivers 1.2% excess return per year.

The study may be useful for fixed-income managers who are considering the addition of emerging market debt to their portfolios to produce better returns and reduce overall volatility.

How Did the Authors Conduct This Research?

The study covers six developed and six relatively liquid emerging markets using data from January 2001 to December 2012. Key relationships are also confirmed with data from 1973 to 2012.

The research is based on local currency returns, measured by the MSCI total return index for the equity market and the JP Morgan total return index for the bond market. Excess returns are calculated over the local currency cash returns, which are represented by three-month local LIBORs obtained from Bloomberg. The term spread is calculated as the excess return of the 10-year government yield over the three-month LIBOR for each market.

The authors first calculate excess return and the information ratio to measure the effectiveness of each investment strategy (i.e., bond momentum, equity momentum, and term spread) for each country. For each factor, given positive bond momentum or positive term spread (i.e., excess return over local LIBOR), the proposed strategy is to take a long position for the one-month period; given positive equity momentum, the strategy is to take a short position. Results are then aggregated into developed and emerging market portfolios through equal weighting.

The next step is to run a multifactor model that represents cumulative use of the three factors for both emerging and developed market portfolios. They take into account transaction costs associated with frequent trading strategies.

Excess returns are calculated in local currency terms as a proxy for a currency-hedged return for a foreign investor. It is important to note that hedging emerging market currencies may be costly, whereas the supply of US-denominated debt may be limited. Although their methodology and calculations seem to be valid, the authors could consider testing each factor for statistical significance to confirm the conclusions.

Abstractor’s Viewpoint

The authors explain that an active strategy based on momentum and term-spread factors may allow investors to generate excess return after transaction costs. Bond momentum that is attributed to a gradual diffusion of information (i.e., language barrier and limited coverage) is likely to create the potential for excess returns in emerging markets.

Overall, the study is comprehensive, but the addition of hedging cost analysis could make it even more relevant from the perspective of foreign investors.

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