Intro: Emerging market and developed market bond yields respond differently to changes in domestic and external real GDP growth expectations. To compare emerging and developed local government bond yields it is useful to adjust emerging market yields for default risk on external debt.
The difference between yields on emerging market bonds and developed market bonds is effectively that emerging market bonds respond differently to real GDP growth expectations owing to the greater existence of default risk. Default risk relates to the possibility that the government will default on dollar debt. Defaulting on local debt is avoidable by the use of central bank’s money creation to repay the debts. However, defaulting on dollar debt can still indirectly impact local currency bond yields because investors will find it more difficult to sell their local currency bonds during times of crisis.
So, even if inflation in an emerging and a developed market are at equal levels, the emerging market country would tend to have higher yields on local currency debt to entice foreign investors to hold the bonds given the higher default risk. As a result, unlike in developed markets where weak real GDP growth tends to put downward pressure on government bond yields, in emerging markets, weak real GDP growth can indirectly result in higher yields as the risk of default increases.
Risk-Adjusted Real Yields
If an emerging market bond yields 6% and inflation expectations are 3%, then real yields are 3%. If this reflects the fact that the default risk as measured by the CDS spread is 300bps, then the bond isn’t very attractively valued because the risk-adjusted real yield is zero. If the CDS spread is 100bps, this gives a risk adjusted real yield of 2%. Higher risk-adjusted real yields suggest there is greater potential for yield compression and bond price appreciation as foreign investors find the bonds increasingly attractive relative to cash.
The Impact of Fiscal Policy On Emerging And Developed Market Bonds
If a developed country implements fiscal tightening, the reduction in the supply of bonds (at least relative to what was previously expected) results in direct appreciatory pressure on bond prices, lowering yields, which is complemented by a fall in inflation expectations. Real GDP growth may be positively or negatively impacted depending on the specific economic cycle. In the case of emerging markets, fiscal tightening measures result in downside yield pressure to an even greater degree, as they also reduce default risk and therefore increase investors’ willingness to accept lower yields.