FxWirePro: Crux between EM bond yield, EMFX, and EMFX vols

We examine three factors – EM FX, EM FX volatility, and foreign net buying/selling of local bonds – to see how different regimes influence valuation misalignments since 2012. Some general conclusions are stated below:

EM FX: When EM currencies are depreciating, the gap between actual bonds yields and fair value tends to increase. The opposite happens when currencies are appreciating.

EM FX volatility: Similar to movements in spot rates, when volatility is increasing (typically occurs when EM currencies are depreciating) the gap between actual bond yields and fair value tends to increase. When volatility is falling the gap between actual and predicted yields tend to decline.

Flows: There is a decent relationship between valuation misalignments and foreign net buying/selling of local bonds (for countries where data is available).

SG’s EM bond yield fair value model uses four variables – two internal (IP, CPI) and two external factors (FX, foreign rates) – and has been able to capture the majority of variation in short and long tenor bond yields.

Like any financial asset model, there will be deviations between actual and predicted yields at different points in time. What causes these deviations can be related to an omitted variable, idiosyncratic country factors such as politics or crisis, policy expectations, or external factors (risk on/off cycles).

In the sections below we explore whether different regimes can help explain valuation misalignments (i.e. when bond yields trade cheap/rich compared to macro fair value).