Common factors in emerging market spreads - BIS Quarterly Review, part 6, December 2003

Emerging market bond debt has become an increasingly important asset class for portfolio managers and, over the last decade, emerged as a key source of funds for emerging market governments. Spreads on emerging market bond debt across countries tend to move in tandem over time, suggesting that one or more common factors drive their movements. Yet despite its relevance to portfolio management, the degree of common variation in spreads on emerging market debt, and the number of underlying factors that might drive this covariation, has received little attention in the asset pricing literature. This article investigates the extent to which spreads on emerging market sovereign debt react to forces that are common across markets. Similar in spirit to the Litterman and Scheinkman (1991) analysis of the US Treasury yield curve, and to the extensive work in the asset pricing literature on the factors driving equity returns, we use principal factor analysis to determine the number of common factors that drive movements in emerging market bond spreads. Three broad conclusions are supported by the analysis presented below. First, we find that common forces account for, on average, one third of the total variation in the daily movement of each spread for our primary sample of 15 emerging market issuers. This result is robust to rating differences, as well as differences in sample size. Second, we find that a single common factor explains approximately 80% of the common variation, although there is tentative evidence of a second common factor emerging in recent years. Third, the primary factor may reflect changes in investors’ attitudes towards risk, as evidenced by its high correlation with economic variables that are thought to reflect changes in risk premia.