EM Fixed Income: quantitative tools for detecting opportunities in EM

Highlights:

• Since late 2023, EM bond valuations have tightened, with external and local debt spreads close to all-time lows. Questions arises whether EM fixed income is expensive and where opportunities lay. 
• EM sovereign fixed income is a heterogeneous asset class driven by global factors but also by relevant local determinants such as political risk, the fiscal outlook, or re-structuring discussion. The construction of a valuation framework to identify opportunities in EM can thus be approached from multiple angles. 
• For external debt, we model the spread of EM sovereign debt yields as a function of country-specific fundamentals and the risk appetite of global investors. We consider 66 and use a fixed effects panel specification. While EM USD and EUR spread were slightly cheap in late 2023/early 2024, current valuations are close to fair value especially for USD spread, but slightly expensive for EUR spread. At the rating level, after a period of expensiveness, EM IG spreads are close to fair value while EM HY are slightly expensive. 
• For EM local debt, we focus on the local term premium for 13 key countries. Our estimated term premia have been ris-ing since 2022 and stand at high levels on average, exhibiting historically the largest gap with the US term premium. Currently, South Africa, Peru, and Turkey offer the highest premium across the EM local debt complex and are close to their 10Y highs, highlighting their attractiveness. 
• We show that the use of term premium in systematic strategies has to be careful. It is a relevant signal for EM bonds outperformance in local terms. However, when considering FX hedging costs for foreign investors, the return of those strategies is less appealing. Systematic strategies based on term premium must focus on countries with the high-est/lowest levels of term premium to provide better returns than the benchmark.

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