Factor Analysis of Emerging Market Bond Funds

Emerging market (EM) bond funds have attracted considerable attention from investors over the last two decades. This is certainly due to the strong performance of EM bond funds compared to other investment classes. From an asset pricing perspective these results trigger the question what are the return and risk drivers of EM bond funds. While there exists an extensive literature on the performance of equity mutual funds, little research has been done to explore these issues for EM bond funds. Thus, this project is the first attempt to systematically analyze the return and risk structure of EM bond investments. We augment the traditional model of asset pricing by bond market factors such as carry, duration and leverage. The carry factor measures the interest rate differential between two currencies and is implemented by buying the high-yield currency and selling the low-yield currency. The duration factor captures the return coming from a change in interest rates and the maturity of bonds, while the leverage factor explains performance contributions of implicit and/or explicit credit. While carry is an important risk factor for EM bond funds, it is still not fully understood what actually drives it. Therefore, we additionally focus on the economic rationale of persistent risk premiums earned by carry trades. The existing literature suggests that credit, volatility, and liquidity risks are essential factors to explain carry trade returns. Yet these three factors have not been considered jointly. Our analysis aims to overcome this gap and answer the question, how investors are compensated when engaging in carry trade strategies. Our analysis consists of three steps: First, we construct the three factors. Second, we conduct a multifactor analysis with the identified factors and systematically analyze the performance of EM bond funds. Third, we set up credit, volatility and liquidity factors and use them jointly in an econometric model to explain the persistent risk premiums of carry trades. The research project is carried out by members of the Research Institute for Capital Markets, a research institute at WU Vienna University of Economics and Business.

For many countries, issuing sovereign bonds represents an important access to international financial markets via which they can raise capital for government projects, such as infrastructure investments. It is therefore of central importance, to understand how investors price such bonds, since this determines the funding costs of the issuing countries. This is particularly relevant for emerging market countries (EM), since they are frequently dependent on this funding channel. The objective of this research project is to improve our understanding of the factors that determine the required rates of return on sovereign bonds, with a special focus on emerging markets. To achieve this objective, we must analyze the drivers of the risk premia implicit in bond yields and the factors that drive them. In the first part of the research project, we analyze the risk factors underlying the returns of EM bonds. We show that EM bond returns are largely determined by three factors: A market factor, a duration factor and a carry factor. We show that these three factors explain up to over 80% of the EM bond returns. Next, we analyze whether investors are compensated for exposure to these three factors, i.e. whether investors earn risk premia for this exposure. To address this question, we need a cross-section of EM bond returns. Therefore, we consider data for EM bond mutual fund returns, which are exposed to these three factors to different degrees. The results show that exposure to the three risk factors goes along with substantial risk premia. However, we find that there is large time-variation in these risk premia. Until the onset of the financial crisis in 2007, the carry factor generated very high annual risk premia. Since the financial crisis, these risk premia have decreased substantially. Analyzing the reasons for the time-variation, and thus of the changing funding costs of EM countries, appears to be an interesting direction for future research. The second part of our research tackles a broader question, namely the drivers of the cross-sectional and the time-series variation of risk premia of government bonds. This part of our research is based on a sample of 40 countries, including both developing and developed countries. Here we also consider a broader set of potential risk drivers. This part of our research represents the first comprehensive study that shows that bond portfolios that are constructed on the basis of the identified risk factors, generate risk return characteristics that cannot be explained by existing asset pricing theories.