Emerging market bond liquidity

Don’t understand something from one of the questions.

If trading liquidity of emerging market bonds is improving, how are investors compensated with increased spreads? Aren’t spreads tightening in improving liquidity environment?

I mean, shouldn’t the investors be compensated with increased spreads if there is lack of liquidity?

As usual, your help is appreciated!

Hi,
I’ll try. My view is:
Tightening spreads of EM bonds from higher liquidity leads to investors able to collateralise from them more easily and reinvest. (thus being compensated from tightening spreads for these products?)

S2000 magician , perhaps you could further enlighten?

Thanks!

1 Like

Are we talking about bid-ask spreads when you mean “spreads” (which go to liquidity) or are we talking yield spreads?

Because yield spreads would make sense here. They compensate for higher risk. Investors require higher yields to compensate for higher risk and thus the bonds are priced accordingly. Since we are in fixed income do they not mean yield spreads in your question?

1 Like

Actually it doesn’t say. It just says spreads. I will presume it meant yield spreads.

I mean, the question is totally confusing, as my understanding that the investors are compensated for holding illiquid bonds (through higher liquidity premium as a compensation).

But please, one more explanation - how are yield spreads rising under condition of improving liquidity of EM bond markets? It may be a silly question, but I’m totally confused with all the information overload :slight_smile:

Tnx!

Here is my layman understanding about EM bonds as someone who recently took L3 and someone who worked in EM fixed income for several years in a prior position:

  1. The universe of EM bonds is increasing and approaching the HY sector in the USA.

  2. Commodity and banking makes up the majority of issuers.

  3. More common occurrence of direct government ownership in issuers can give more faith in their creditworthiness but also can give rise to operational efficiency and transparency struggles. And when trouble hits, the local government often can favor helping domestic investors over the foreign investors due to political populism, crony capitalism or social reasons.

  4. EM corporate bonds have a sovereign rating ceiling (they cannot be rated better than their government’s sovereign bonds) so sometimes EM corporate bonds for a well run company can have “understated” ratings due to their government being not as well run as the company is.

  5. Liquidity is improving but it’s still a concern to keep in mind. Particularly as global economic situations change or the domestic economic/political situation evolves. When shocks hit either due to global recession or commodity cycle fluctuations or political risk or currency risk in the issuer country happens, fixed income investors will do a flight to quality. This means dropping that Belarus eurobond that was so attractive in good/stable times and parking the money somewhere safer. Also a lot of EM debt is issued on the understanding it will be refinanced. During the European debt crisis of 2011, for example, EM access to debt markets for refinancing at acceptable rates can dry up temporarily. This causes issues and even can give rise to risk of technical defaults.

  6. Currency risk and legal risk for EM bonds is higher. Currency is riskier for all the reasons you learned in L1-L3 about smaller export-reliant economies with weaker domestic economic regimes, etc. Also if the EM bond is in dollars (a Eurobond) then you can have basis risk due to bond obligations being in dollars (or Euros, etc.) but the cash flows generating revenues to pay the bond are in another currency that can experience inflation or depreciation for all the reasons you’ve studied in L1-L3. Legal is riskier because rule of law can become more arbitrary than in more developed economies and enforcement of investor rights (or even stability of laws) protecting foreign investors particularly can be unpredictable.

So while liquidity is improving, you have additional risks with EM bonds that require additional compensation. They will trade at higher yields (and be issued at higher coupons) even if they are denominated in dollars or Euros. Also, if political change or conflict happens in the issuer country, it can really cause problems. And local corruption among political/oligarch classes that can ultimately control large issuers or the local court system is often an unavoidable hazard that comes with the territory.

Maybe someone has additional thoughts/corrections to my comments above, but this is my understanding at least.

Cheers - good luck - you got this👍

2 Likes

Thanks Grey for such an exaustive clarification :wink:

1 Like

I have but one simple goal on AF, and that’s to help every person here crush their exams if I can. I am not a rare super genius like s2000 is, but I do want to try to help however I can whenever I can here.

Just remember you totally can smoke L3, you got this, good luck, go crush it :+1:

2 Likes